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.
I think for any reasonable large scale investor with a social responsibility/mission (e.g. typical VC investors such as endowments, pensions and the like, which need to focu and worry about the basic needs of its constituency not just absolute returns over time) then the criteria for any alternative investment should be the ability to generate 300-400 basis points above a conservative diversified laddered bond portfoliosuch a laddered portfolio typically will beat inflation by several hundred basis points (i assume inflation at 2-3% per annum). which for such investors should mean “mission accomplished” with little risk and decent liquidity. and that means their constituents — the universities and philanthropies and pension plans — can sleep easy and rest assured their future isn’t being wagered on unnecessarily risky betsso can VC or LBO or real estate — or even public market equities — beat inflation by several hundred basis points beyond returns from a fairly plain vanilla bond strategy?its not clearLBO has done so, handily for a decade. VC did so for most of its existance, but in the last decade has failed, not even close really, what with the combination of too much capital raised and exorbitant management fees crushing returnsand if in fact VC can generate 10% IRR that would be an edge case — arguably a win over a bond portfolio but so close and so dependent on buying into the top decile of funds for the period, that it may not be worth it.
A brief comment – a conversation about the “illiquidity premium” and how that effects an investment strategy is ill served if it doesn’t touch on diversification and how this asset class fits into an overall strategy.r.
good point but i am not well versed in that and i don’t feel equipped to address that. ideally someone will in the comments
As usual, an interesting topic.Illiquidity, in many ways, is in the eye of the beholder. A VC and a LP (typically a pension fund) may have entirely different temporal frames of reference.The 15-year time horizon that Fred paints for the real life of the fund with gradual outflows in the early years tempered by gradual inflows in the later years is not a particular issue for the actual funding source — the LP — while the VC (and management) usually thinks that a quick trip to the pay window cures a lot of ills to say nothing of the fact that the VC is not getting any younger and actually wants to spend or enjoy some of the profits.The LP has funding requirements which may literally go on forever while the VC and management have braces, college tuitions and airplanes for which to pay.The solution to liquidity — if it is perceived as a real problem — may be as much a banking challenge as anything else. Get into the private wealth management shops of the big banks and borrow like a crazy man against those assets — of course, you are going to have to tattoo a personal guaranty.Remember interest rates are almost nothing these days.If you can start with a solid base of real estate (homestead, lake house, ski house, beach house, etc), you would be surprised how much other stuff can be stuffed into the pooled collateral. Banks particulary like stuff they can actually hold (like stock certificates and securities) in the vault.When I started out in business, a very wise investor told me to spend 25% of my time on my own personal finances and 75% on business. Never invest my own money in my own deals. Use OPM cause OP have a lot of M and remember some folks only inventory money. Take your profits off the table and never commingle your personal and business finances.
That’s all great advice but the private banks won’t lend me any money against anything other than marketable stocks and marketable real estate right now
i think one of the major trends we’re going to see over the next few years is a greater desire to diversify outside of US/dollar-denominated investments. International stocks, international bonds, international private equity funds, and virtual economies i think all stand to benefit from this. i think US stocks, US bonds (particularly treasury bonds), and US private equity will all lose out of this and forced to become more competitive and efficient in order to survive.
Yup. I’m working on a program that will ultimately get 20pcnt to 30pcnt of our liquid net worth out of the US dollar. I’m taking an approach to average in over the next few years because I think its possible that the dollar gets stronger for a little while longer
for real? wow, i think that’s great. if you’re ever willing/able to share more about what non-dollar investments you’re making i think that would make for great community discussion.
Thinking canadian and aussie dollars for sure.China and euro as maybeAnd second life lindens just for you Kid!
i’m working on creating virtual financial markets, hopefully i’ll be able to convince you to shift a portion out of linden dollars and into MercBonds — interest-bearing bonds issued by Kid Mercury’s virtual world! we’ll even have a liquid market for you to buy and sell MercBonds, and of course, yours truly will be the buyer of last resort should there be no buyers for MercBonds. no illiquidity premium here, boss!
Nice to see what’s underneath when the glitter and glory of VC investing is brushed off. Not to say what you are telling us is bad in any way, just that VC investing is glorified almost as much as the guy starting from nothing and becoming an overnight success. It rarely, if ever, happens that way. It’s good to see someone put that out there.
Are there any VC funds of funds? If so, do they include some of the ‘best’ ones?If I’m not mistaken there is a huge variance in the returns from different VC funds, with only a small number of the best funds accounting for the lion’s share of the overall results.In the absence of well-distributed (and high capacity) funds of funds, would you agree that any talk of a generalized return from the ‘ VC asset class’ is potentially quite meaningless?
there are many fund of funds and some very good ones
So you’re saying it’s not too hard to gain exposure to the aggregate VC asset class return?
You have to pay fees to do that which many don’t want to do. But I do think its possible
Hmmm, shouldn’t that be “illiquidity discount?”
illiquidity [risk] premium ??:-)
This post made me think of something. Has anyone every tried investing in a company like a line of credit. i.e. USV chooses to invest in my company at the $1MM level and that $1MM works like a credit line for the company at whatever valuation rate they are at. So let’s say my company decides to draw $100k out of that $1MM approved VCLCE (Venture Captial Line of Credit Equity) at $1 per share and then 3 months later decides to pull another $600k of it at $1.50 per share when they need more of it.My thought is as startups are more risky these days because there are fewer exit strategies available this would benefit the startup because they only would take what they need and since the VC would be on their board they can advise and vote for or against each ‘draw’ against the VCLCE and it would protect the VC from diving in on companies and tying up money as they see companies going south, they can turn off the spigot and re-allocate funds and essentially manage their portfolio companies in a more fluid fashion.Anyway, I’m no finance guy and it’s probably a half baked thought, but I was just curious if you came across it and what people thought the pro’s/con’s would be.
i’ve seen deals structured like that. often bridges are structured that way. but it works against the desire to get a minimum amount of ownership in a company.
I’m familiar with convertible bridge notes. I’m talking about more of an equity situation. I agree that the VC’s interest would be to get a minimum amount of ownership but theoretically if the company wasn’t drawing the full line then they wouldn’t be growing at the rate that was initially expected when the investment was made and the VC’s money would be better shifted elsewhere, so I guess for the VC maybe there could be a fixed share price despite the valuation of the company which would be a risk that the company would need to evaluate. I guess my point was that VC’s are looking for safer ways to invest and it’s harder for companies to raise money. My thought was this might be a more flexible way for VC’s to get into more companies without draining their whole fund and limiting risk and give those companies a way to ‘earn’ their way into the capital they need.
We do that by starting with a very small investment of somewhere between 250k and 500k and then slowly scaling that investment up to approach 10mm over four or five years
i saw you tweeted this and came back here. are you saying that you are thinking of something else?
yea, i guess now disqus automatically tweets your comment if you have it set up that way. i think i like that.Yea, so I mean as a first time entrepreneur I feel as though we are definitely having a tough time raising seed money and VC’s right now are much more cautious than the used to be in investing in companies. The criteria that used to warrant investing are now much higher and my thought is a lot of early stage startups are throwing in the towel as a result which ultimately slows down innovation across the board in our industry.My thought is I’m trying to come up with a more dynamic way of investing in an early stage startup that allows companies to earn their way into a round rather than an all or nothing scenario and you are pretty much describing to me the way things are.The current method of a VC committing a dollar amount and whether milestones are met or not their money is into that company. So that is to say whether your first investment is $250k or $1MM you want to buy in more if it’s successful and you wish you got some of your money back if it’s unsuccessful. Maybe this can be done with like a reverse conversion clause.For example, a company seems promising, they need $1MM to get things going. You commit $1MM and you know they physically need to use $500k to keep the lights on in the next 6 months. So they draw in $500k and it is actual preferred stock value. The second installment if certain milestones are met converts to the same preferred stock at the same value as the original to get the VC to the minimum ownership that they desire if things are successful. If it’s not successful and milestones aren’t met then the company as the option to draw that second $500k and it converts to a note so kind of a reverse convertible note so that the VC can re-collect that money as interest bearing debt or at a premium value using a discount to equity or as a loan that the VC can draw back.
I like to make an investment in a structure where the entrepreneur is incented to create more value before the next financing. An equity “line of credit” with a fixed price for the equity doesn’t do that
gotcha. I think one thing is I don’t fully understand the investment motivation and timing of most VC’s. It really seems like a game of chess. I think I’ll just focus on product development and sales and when the VC time comes maybe I’ll understand things better. Thanks for the feedback.
illiquidity premium is about to soar IMHO. currency instability sends illiquidity premium through the roof. i.e. imagine what the illiquidity premium is like in zimbabwe or iceland, or any economy characterized by political and economic instability.IMO there are two likely scenarios:1. illiquidity premium demanded by investors rises to such an extent that VC as an asset class in its current formation becomes impossible, the illiquidity cost becomes too intolerable2. VC industry gets disrupted by a model that can reduce illiquidity premiumIMHO a return to “normal,” i.e. “the good ol’ days,” etc is not a realistic option and has virtually zero chance of occurring.#2 is a scenario i like, via the creation of virtual economies, which will pave the way for a whole new set of virtual financial markets, which will disrupt the financial markets of the “real” world (meaning the matrix of lies we live in). in this way a new world order is created.i talked a bit more about this in my blog post on the song i dedicated to the venture capital community. ultimately, though, before venture capital can return to being an appealing asset class, we’re going to need a return to capitalism — meaning stable money, free markets, and individual liberty.
The “normal” we are getting ready to “return” to is Country Squires, khakis, topsiders, Leave it to Beaver and vanilla ice cream. Of course, we will likely live forever.We have fallen down a couple of parallel curves and we are not likely going to be able to get up any time soon. The UK has a top tax rate of 60% + and we have not yet pegged ours to anything. Whooooooa, Nelly!Ironic — just when I begin to feel like hiding my assets out of the country, the Swiss get their butts in a crack!
I could have written this comment for you kid!But your point about unstable currencies increasing the illiquidity premium is a damn good one
lol, yeah you def could have written this comment for me. i have way too much fun on your blog!
http://bits.blogs.nytimes.c…This presents an interesting idea, albeit slighty off topic – but still topical.
So… illiquidity premium = liquidity premium right?Maureen O’Hara has written stuff on this that you’ll probably like:http://www.afajof.org/afa/a…”In this context, liquidity is akin to a tax or a cost borne by investors. It seems to me that if these costs are large enough, they should negatively affect asset prices because of their effect on net asset returns.6 In the same vein, reducing these costs through, for example, the introduction of a more efficient trading mechanism should have an immediate positive effect on an asset’s value.7 The microstructure of the market influences these liquidity costs, and so if the effects are large enough, microstructure and liquidity affect asset returns.”
Thanks for that link
There are a number of people trying to attack this liquidity problem by establishing private secondary markets for illiquid shares. SecondMarket is one of them.Just curious about your thoughts on this model, Fred. What would you do if your LPs wanted to trade out their stakes in USV? Or, if your portfolio company employees began selling their own companies’ shares in private-market transactions? Do you think the institutional bias against such trading dooms the models, or is there real potential here? Not sure if you’ve ever posted on this topic, but I’m sure you have thoughts on it, which would be interesting to read.
I’ve posted extensively on this topic and am a huge fan (with some caveats)Anything that can reduce the illiquidity of the asset class and our investments is a good thing in my book
Another great post Fred, thanksIs the PE/VC aftermarket still fragmented or are there leaders emerging? Is their activity up or down in this market?
What do you mean by the aftermarket?
sorry, should have said secondary markets – the sale of LP interestes or even direct interests
The reporter asked the money question, but the answer is probably more nuanced than just comparing public market returns to this asset class.One dimension is timing: the initial period where capital gets called in may be an awful period to get into the public/liquid markets.The other is active management in exchange for illiquidity. Just last week I was pondering (http://bit.ly/55dt1) the implications of listed companies like Intel refusing to forecast the rest of this year because of “adverse economic conditions.” You’ve got liquidity with INTC but you are flying blind. On the other hand, my LP reports are telling my investors exactly how their investee companies are dealing with the downturn and what we are doing to help them meet their numbers. I believe, they care abour our returns and also about how we got there. It allows them to make smarter investing decisions overall.
I can assure you that we care about the returns our investors get in our funds
Good comments all. Certainly I agree with Nivi that capital flows do not even remotely correlate with actual returns, but probably correlate with expected returns – and even then if too much capital comes in – may actually contribute to negative returns. Consider the distressed debt market, where I worked for the past 3 years. Last summer, I attended a Credit Suisse distressed conference, and couldn’t even get in the room to hear an analyst explain why Tropicana bonds were worth a lot 80- when they traded at 50. Current bid is 0 (their actual value) Too much money chasing too few god ideas is generally the way it is put.There’s another interesting comment regarding time horizons buried in this comment stream. Everybody knows that private equity and vc investments are illiquid and have long tails – so why has it come as a surprise to many investors in these asset classes when they run out of money elsewhere? You have seenthis time and again over the past year or so – complains of locked up money and secondary sales – not because VC or PE has done anything different (okay the PE guys did over leverage the hell out of their portfolios and never take writedowns) but because their other parts of their portfolio tanked so badly. Endowments have very long time horizons, but also use part of their portfolio to support the institution. Pension funds have very long time horizons, but must meet current payments to past employees.It would seem to me that the intelligent thing to do is for all of these institutions to make sure their short term needs are met with short duration assets (or long duration assets that are coming due – and that’s the tricky part with PE and VC as you can’t anticipate the timing or size of returns) and take the incremental 10% or so and keep it in the longer duration pool. It’s not rocket science – but with so many people trying to benchmark themselves against institutions that take more risks – it becomes increasingly difficult to weigh the good of the institutional pool of capital against your own job security as the CIO – so you take more risk – and it ends in tears.If VC can provide a 10% boost in returns over the long run – then it is well worth investing in – if, and this is the most important point – you have the proper time horizon.
Harry – you have hit the nail on the head with this comment
“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.”This doesn’t make sense to me; most people are familiar with real estate and its illiquid nature. In fact, your entire post is a great example of why most people should NOT buy real estate (or invest in venture capital funds). It is interesting that, on the one hand, in the case of real estate, the government provides a set of perverse incentives for people to enter into an illiquid investment, and, on the other hand, in the case of venture capital funds, the government doesn’t provide any incentive for people to invest.
Private equity and venture illiquidity is different than real estate. You can always sell real estate and even if the market is down, you aren’t looking at a 60pcnt to 80pnct haircut because the security is illiquidI’ve heard from some of our investors that there are literally no bidders for some of their funds at any price
Give them my number. I’ve got a standing bid of 21 cents on the dollar.
I don’t think they are as different as you indicate. There are a number of buildings that aren’t trading “at any price” right now. In either case if there are future capital funding requirements then quoted price is not reflective of the true cost of ownership anyway. If an LP interest is a asset not a liability (or at least a free option) then it sounds like a failure on the marketing side not the demand side. Most of the time the seller is not really ready to sell “at any price”
There is a downside to liquidity too: Emotional, reactive decision making and premature exits by the investor. Part of Buffet’s success is that he took advantage of liquidity to ENTER positions, but with the attitude that the investment would be made as if liquidity would not be available for at least 5-10 years.Liquidity is often a false benefit….at least in my personal experience.
Very true. I’ve made a fair bit of money on IPO lockups
I read from New York Time that some VCs were thinking to use sites, such as secondmarket.com, as an alternative for investment exit.
Typically, the “market answer” implies very efficient flows of information, balanced pricing and rational investor behavior while VC by its very nature is specialized, compartmentalized, secretive, cannibalistic, hugely forward looking and thereby inefficient.When one begins to look at a “normal” investment matrix from equities (large cap, medium cap, small cap, micro cap, nano cap & international, emerging and domestic, political risk adjusted, etc.) and fixed income to real estate and VC, etc. — granted all for big pension fund type investors — it is a daunting task to see how VC even fits in to say nothing of its increasing complexities and subdivisions. It is the UFC of the investment world.VC is not transparent — witness the controversy of private VC funds taking public LP monies and objecting to public reporting of financial returns by either the funds or the LPs — and this obscures returns. There is a lot of fable and urban legend at work here.Actual returns are built of widely varied real returns — 33% misses, 33% singles, 33% long balls with men on base — and just a bit of mathmatical alchemy can go a long, long way. People are still trading off what they did 25 years ago.When you look at the repricing exercise we have just lived through (which in my view will be completely absorbed and irrelevant in less than 4 years), it is very difficult to look 25-50-100 years down the road as the typical pension fund must do.It’s like drinking from a fire hose but one that you have to use “stop loss orders” to be able to sleep at night.We are living the Chinese curse of “interesting times”.Of course, a 50:1 horse won the Derby this year, didn’t it?
I believe that markets are right over the long haul and sometimes very wrong in the short run
JLMI was in austin today for lunch and an aft meeting with UTIMCOThen a dash to the airport just to wait three hours because the weather sucks in NYCThe whole time I was bummed that I didn’t have time to stop by and finally meet youNext time I plan on fixing that
That’s a shame because I was around all day. I had lunch @ Louie’s 106 one block from UTiMCO’s offices.
Institutional investors that invest in alternative investments like hedge funds are also faced with illiquidity. I interned for a long/short equity fund and it’s typical for funds to have a lock-in period. Maybe not for 15 years as you described, but anywhere from 1-5 years.As we seen in the recent financial crisis, investor are not able to redeem because portfolio managers do not want to sell current investments at low prices.It’s a problem for all institutional investors that want to invest large sums of money and expect great returns (which hedge funds have generally beaten the market in past years) but there are trade offs such as risks, illiquidity, ponzi schemes, etc (especially during economic downturns)
Benjamin Graham used to say (I’m paraphrasing) in the short run, the market’s a voting machine; in the long run, a weighing machine.
The hedge fund illiquidity premium has to be less than private equity and venture. But I agree there has to be one there tooOn the other hand, allowing investors like VCs and hedge fund investors to take the long view and be patient investors contributes greatly to the enhanced performance