The benefits of illiquidity in private markets.
Friction can be a good thing.
The first conclusion from the chart below is that private capital makes up less than 5% of global financing markets.
Over the past decade, global fixed income markets have increased $42 trillion, the global equity market cap has increased $35 trillion, global assets on banking sector balance sheets have increased by $34 trillion, and the global amount of private capital AUM has increased $8 trillion, see chart below.
The second conclusion is that private capital has over the past decade grown much slower than global financing markets.
The bottom line is that the alternatives industry is small, and has over the past decade grown much slower than the rest of the financial system.
The illiquidity premium
Academic research has shown the historic persistence of an illiquidity premium - the excess return received for tying up capital for an extended period of time.
This makes intuitive sense because the private fund manager has ample time to source opportunities and unlock value. The fund manager isn’t beholden to investors and shareholders, like their public market equivalents, who are viewing results over shorter intervals. While the magnitude of the illiquidity premium will vary over time, depending upon the market environment and the fund, the data show that private equity (including VC) has historically delivered a substantial illiquidity premium relative to their public market equivalents.
Institutions and family offices have long recognised this illiquidity premium and consequently have historically allocated significant capital to private markets.
In fact, according to a UBS Global Family Office Report, Family Offices have allocated roughly 45% of their portfolios to alternative investments, with private equity and real estate representing the largest allocations at 19% and 13%, respectively.
Up until recently, HNW investors had limited access to these elusive investments due to HNW investor eligibility and high minimums. However, due to product innovation and a willingness of institutional-quality managers to bring products to the wealth management marketplace, HNW investors now have a broad array of options to select from.
“With the recent fund innovation of the last ten years, HNW investors can now access the private markets at lower minimums and gain more flexible features.”
The behavioural benefits of illiquidity
Daniel Kahneman was awarded the Nobel Prize for his research of behavioural finance, how the brain responds to certain stimuli and the biases that we all exhibit. One of the behavioural biases that Kahneman studied was “loss aversion.”
His research concluded that for the average investor, the ratio of avoiding losses to seeking gains is roughly 2:1. Consequently, investors may fall short of their goals by being too conservative or leaving the market in times of volatility.
Of course, there is a built-in benefit of allocating a portion of your portfolio to illiquid investments—it removes the emotional impulse to sell at the wrong time or switch strategies midstream. By utilising an illiquidity bucket for a portion of your portfolio, can instil discipline in your investment approach.
In the private markets, you can’t sell at the first signs of volatility or the temptation to chase returns elsewhere. Meaning, generally speaking, these assets are truly long-term in nature and will require patience to reap the full potential benefit.
Venture Market Liquidity Options
A lot has changed in the 50 years or so since Venture Capital has been around. Particularly from an optionality perspective when it comes to liquidity events. Even just 20 years ago, most managers and founders depended on taking a company public via an IPO in order to make a return on their illiquid investment.
Private markets M&A was less common in 2000 and therefore much less of a viable liquidity event compared to nowadays. Although the value of some acquisitions 20 years ago were comparably high, the number of M&A transactions was far lower.
In todays private markets, M&A is a viable option, as well as IPOs and increasingly, secondary share sales are happening more frequently when early investors want to return capital to LPs and/or Founders want to make space for new investors on the Cap Table.
In summary, whilst the historical data shows that alternatives have performed well compared to the public markets, it is still a minuscule slice of the overall financial markets. But with an increasing ability to gain access and the barriers of entry dropping year on year. The possibility of Individuals and families getting to participate in the upside of the illiquidity premium is becoming a reality.
Until next time.
Saludos,
Archie, Bernardo and Victor
If you are interested in learning more about what we are building at Nascent, please reach out!
Archie@nascent.vc
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