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Liquidity Premium

What is a liquidity (or illiquidity) premium?

A liquidity premium is an incremental return that compensates an investor for owning an asset that is not highly liquid. (Because the premium applies to assets with less liquidity, the term is also commonly referred to as an “illiquidity premium”.) Liquidity or illiquidity premiums are general terms rather than absolute numbers, and in most cases, can only be estimated.

Liquidity refers to how easily an investment can be converted to cash. Assets with public markets, such as listed stocks, ETFs, and US Treasury bills, are considered to be highly liquid since they can usually be sold at any time at the prevailing market price. On the other hand, assets such as real estate, private equity, venture capital and many debt instruments are understood to have low liquidity.

Liquidity is also related to the duration of an investment. Stated another way, a liquidity premium is an additional return that investors expect as compensation for tying up their capital for a longer period of time or for not being able to access their capital at all.

Assets that are less liquid expose investors to risk factors that can be greater than those of equivalent liquid assets such as price volatility, economic risks, and asset-specific risks such as the potential for lower earnings or a default. In addition, less liquid assets present an increased opportunity risk, as they cannot be as easily liquidated to take advantage of better opportunities that may arise. The additional risks associated with less liquid assets cause investors to require a higher return from those assets over more liquid alternatives, creating liquidity premiums.

Private equity has characteristically low liquidity and there are times when private equity investors do not have access to their capital at all. Accordingly, investors expect a higher return from private equity funds, which have historically been able to deliver excess returns through the unique strategies they employ.

Key Takeaways

  • A liquidity premium compensates investors with a higher expected return for investing in less liquid assets.
  • Private equity is inherently less liquid than public equity, so investors expect higher overall returns from private equity.
  • While private equity is less liquid than publicly-traded equities, it provides investors with opportunities to invest in earlier stage companies, innovative technologies, novel business models, and other unique investment opportunities.

Are there any benefits to illiquidity?

Investors do not generally seek out investments simply because they are illiquid. They seek out investments that offer attractive risk-reward or diversification attributes and they accept various degrees of illiquidity to access such investments. Thus, a primary benefit of illiquidity is that it can provide access for investors to assets, opportunities and strategies that are generally unavailable in more liquid forms.

This includes opportunities in new technologies, business models, or other innovations that can generally be found often in private companies as well as more complex, value-added investment strategies, such as venture financing or buyouts, which require longer holding periods to fully execute.

Another advantage of owning less liquid assets relates to investor behaviour. Studies have shown that many investors tend to sell profitable investments too soon (a tendency psychologists call the “disposition effect”) or otherwise attempt to time the market with their purchases and sales.1

On the whole, such behaviour tends to have the unintended result of causing investors to underperform as a result of such actions. Owning a less liquid asset could therefore help many investors avoid behaviours that can be detrimental to their returns.

Moonfare’s Secondary Market

Recognising that liquidity may sometimes be necessary or desirable among private equity investors, Moonfare has initiated a feature for its investors whereby a semi-annual secondary market is implemented digitally through its online platform. This structured auction enables eligible investors looking for early liquidity to sell their allocations to other members or to Moonfare’s institutional partner, Lexington Capital.

The secondary market feature allows investors the opportunity to either dispose of their fund shares or acquire additional shares during defined time windows in the spring and fall. While not a guarantee that an appropriate counterparty will be available, the feature offers a unique benefit to Moonfare investors that is not available through other private equity fund issuers.

Important Notice

This content is for informational purposes only. Moonfare does not provide investment advice. You should not construe any information or other material provided as legal, tax, investment, financial, or other advice. If you are unsure about anything, you should seek financial advice from an authorised advisor. Past performance is not a reliable guide to future returns. Your capital is at risk.

1 https://www.sciencedirect.com/science/article/pii/B9780444594068000226

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