• BusinessValuation

Illiquidity Discounts

In recent years, Private Equity (PE) is becoming more correlated to public equities. For a ten-year bear market for stocks, most of the forecasts for PE would be not to act as a big portfolio diversifier. Still - this didn’t bring PE to its full potential as PE, like all portfolios, will diversify away much of the idiosyncratic risks.

One of the dangers of PE is its high volatility, which is also its unique features.

Liquid, accurately priced investments, tells its precise volatility and still hits investors hard with losses. Many investors would realise that the accurate and updated information about liquid would lead them to poor investments and hence use liquidity to panic and redeem at the worst timing.

Illiquidity on the other hand, with its irregular and less accurate price investments, has low measured volatility and more modest paper drawdowns hence allowing investors to stick through the harrowing times when there are thoughts to sell to avoid a possible loss.

Would PE then be a good investment for those who are able to take on more risks or risks in a longer term? Would these investors also find a levered publicly traded small-cap portfolio less worthy to stick with even though the latter is economically worth investing?

This depends on the lower expected returns compared to the risks in the liquid and marked-to-market investment. Investors needed simple heuristics, sometimes illogical but workable, based on their experiences.

Or in the case of dollar-cost-averaging, it is like receiving two portfolios - one the final equity portfolio; the other all cash - and then not choosing the desired one but averaging between the two slowly until there is minimal regret.

In conclusion, an action from an investor is not likely a rational one when there is a narrow return or risk involved.

Illiquidity, being infrequently-priced assets, wouldn’t hit an investor with their volatility with the same illogical rationale. Perhaps a levered small cap portfolio would be a rational investment for long-term investors, but they usually wouldn’t keep to the investment for the full cycle. They may instead find PE easier to stick to for the full cycle.

What is then the implication of extreme illiquidity and pricing opacity being a feature and not a bug?

It is a question of paying up in price and giving up in expected return for features that are valued instead of the bugs that can’t be tolerated.

Naturally, attractive smoothness of returns do not come for free; if illiquidity allows more positive returns than negative to many investors, it could be the higher paying price and accepting a lower return to obtain it, which sounds counterintuitive but is actually plausible.

With the fees and other features of PE, it is likely that investors are paying a bit higher price and accepting a lower net expected return that could be analogous to a levered small-cap portfolio. But they also received an investment they would stick with in the longer run.

This means the investors are accepting a discounted expected net return, which is discounted from a high level based on the original levered small-cap not a low-risk, low-return investment, for the privilege of not knowing the prices.

It may be frustrating to believe for those who had become familiar with liquid and accurate mark-to-market pricing. And there are illiquid assets with smooth returns too.

Hence there is an illiquidity discount in expected returns with the opposite sign from the illiquidity premium that was usually assumed. Investors dealing with PE would know that they are into a serious, smoothing and palatable volatility. They may not expect to get a return advantage. But they would receive half of the ‘free lunch’, which is mindblowing.

There is a reason why PE is growing in popularity and there is an increasing acceptance among investors to be aggressive to achieve their goals, such as living with underfunded pension plans. More investors also possess an absolute aversion to living under the true reported volatility for such aggression.

Liquid, truly uncorrelated alternatives actually diversify a portfolio in the short and long term. They offer real diversification instead of those from not reporting actual returns.

It would require the investor to live through the painful time in order to taste success.

Illiquidity is perhaps a better portfolio than the very correlated alternative assets at an expected return discount. It would be better if the investor lived with the idea.

Moving from a better portfolio to a worse one would work only when the investor knows what he/she is doing and has the correct mindset - not just because it is easier.


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