Last week we looked at the possibility of adopting much more aggressive equity allocations than most of us would normally be comfortable with. We found that a portfolio allocation of 90% to equities looked more interesting than we might have expected, but that it presented some serious behavioral issues. This week we’ll look at the role illiquid investments might play in our future portfolios.
There are trillions of dollars of cash sloshing around in the investment markets globally, but all but a tiny fraction of this either can’t tolerate illiquidity or doesn’t want to tolerate it. For this reason, as well as for reasons having to do with capital markets theory, investments that aren’t immediately liquid offer investors a return premium over similarly risky investments that are liquid. A simple example familiar to everyone is that a savings account typically offers lower interest than a 180-day certificate of deposit offered by the same bank.
Most large pools of capital – as held, for example, by governments, banks, insurance companies, sovereign wealth funds, and individuals – don’t invest much or at all in illiquid investments because they are constrained by immediate spending needs (governments), are prevented by laws and regulations from tying up their capital (banks, insurance companies, non-accredited individuals), are simply disinclined to tie up money (most, though not all, sovereign wealth funds and individual investors) or they lack the requisite skill to be successful. This leaves pension funds, endowments, and wealthy individuals as the only significant providers of capital globally to illiquid investments. As a result, except during unusual periods (e.g. the Tech Boom of the late 1990s) there will always be more interesting illiquid opportunities available than there is capital to invest in them.
Illiquid investment opportunities typically arise for one of two reasons. First, it may simply be inherent in the nature of the opportunity that it takes a while for it to play out. A venture capital investor injects capital into a small startup company hoping that it will grow and eventually go public or sell itself to a larger entity. A private equity firm takes a company private, hoping to improve its prospects and performance and then to take it public again or sell it for a much better price. But none of this is going to happen overnight. Venture and PE firms need patient sources of capital in order to do what they do.
As an example of the second reason for illiquidity, consider a hedge fund that invests in securities that are usually reasonably liquid but that, from time to time, become illiquid due to unusual market conditions. The hedge fund knows that this is precisely the time to buy those securities, but the fund also knows that it doesn’t want to buy them and then find that many of its investors want to redeem their capital – probably as a result of the same conditions that made the securities interesting. As a result, the fund requires a lockup that might range from quarterly to annual or even longer.
A few investment funds take this logic to its ultimate conclusion and offer funds with lives measured in decades. Investing in such a fund is similar to owning a private company (albeit one you don’t control) in the sense that you are building net worth and producing at least some income along the way, but the ultimate goal is to maximize long-term wealth way down the road. Of course, most such firms pay little attention to shorter-term downside risk.
Of course, it’s one thing for illiquid investments to promise above average returns – it’s quite another actually to deliver those returns. In the venture capital world, for example, there are no more than 20 or 30 funds – out of hundreds of options – that have consistently delivered returns that justify their risks and illiquidity. The odds aren’t quite so bad in private equity (buyouts, mezzanine, etc.) but you still need to be with top quartile funds to generate decent results. Hedge fund returns, as measured, for example, by the HFRI Hedge Fund of Funds Index, are almost a joke. As with PE, you need to be invested with the top funds.
The bottom line for investors who want to profit from illiquidity is that you need to identify areas of appropriate illiquid opportunities and you need to invest with the best managers operating in each sector. Interesting opportunities will vary from time to time, but they will typically be found in venture, PE, private real estate, long/short hedge, and similar sectors. And unless you are skilled and experienced in sourcing and evaluating illiquid investments and the managers who operate in those sectors, you would do well to hire an advisor to work with you. Advisors don’t work for free, of course, but their fees (typically starting at 30 to 50 basis points/year) are chump change compared to the 3% to 5% and up you can expect to earn above liquid market returns in a successful illiquid investing program.
Next up: Getting Rich in a Poor Market, Part IV