The Illiquidity Premium

I was talking to a reporter yesterday who is working on a long piece about private equity and venture capital returns.

She asked me how much the “alternative investment” class (aka venture capital and private equity) needs to outperform the public markets to make it an attractive asset class.

I don’t know the answer to that. I suppose there’s a theoretical answer based on some advanced math. But there is also a market answer. If capital leaves the alternative asset class for the public markets we’ll know that the returns are too low relative to public markets. And if capital flows back to the alternative asset class, we’ll know that returns have reached a level where these private markets are more attractive than the public markets.

There are a number of reasons why public markets are preferable to private markets (all else being equal) but to my mind, the big one is liquidity (and the lack of it in the private markets).

I am not an investor in a single buyout or private equity fund so I cannot speak intelligenty about the illiquidity of those funds but I assume it is similar to venture capital.

A venture capital fund generally has a ten year term. But in my experience it often takes a bit longer, possibly fifteen years, to exit all of the investments.

If you invested $1mm into a typical VC fund, you would not be locking up that $1mm for ten to fifteen years. The $1mm would typically be “called” from you mostly over the first five years as it gets invested. There would be some amount, less than 20pcnt, left for calls in the second five years.

The way I like to model it is 18pcnt per year for five years and 2pcnt per year for the next five years. The USV funds we manage have capital calls that look more like an s-curve than a straight line but that’s getting too granular for this post.

The money comes back to you in the latter half of the fund. I like to model it as 40pnct per year for the last five years and then 10pcnt per year for years 11 through 15. That assumes the fund returns 2.5x net to the investor which is a very good return for a VC fund.

So you can look at the numbers and see that you are out the money for a considerable period of time.

And if you want the money back on some other timetable, you have very few options.

You cannot ask to be redeemed. It won’t happen. You can try to sell your interest in the ‘secondary market’ and you will get between 20cents on the dollar and 40cents on the dollar for all but the very best funds.

So venture capital and presumably private equity as well is a very illiquid asset class.

Contrast that with a mutual fund. You want out, you get out at whatever the current market value of your fund interest is.

It is very hard to wrap your head around what illiquidity really means until you experience it first hand. Then you know its a very undesirable feature for an investor.

So, in summary, when I was talking to the reporter yesterday, I noted that the ten year returns for VC are between 5pcnt and 10pcnt whereas the S&P is negative by something like 5pcnt (I’m on a plane and can’t look it up).

Is a 10pcnt excess return enough to incent a rational investor to part with their money for an extended period of time? Maybe, it depends on who the investor is. But it certainly is not a slam dunk in my mind.