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Balancing liquidity and illiquidity in private market investments – 5 key considerations

It might be tempting to assume that all private equity investments are difficult to exit and so best given a wide berth. The reality can often be far from that. Here we explore why and set out the main questions for prospective investors to consider.

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It is among the last things that any investor wants: to be stuck with an asset they no longer wish to own but are simply unable to sell. It is therefore hardly surprising that the commonly held view is that an ‘illiquid’ investment, or one that is not easily tradeable, is a bad thing and should be avoided.

The reality is more nuanced. There are plenty of benefits in owning illiquid investments, just as there are pitfalls in holding highly liquid positions. For the best private equity investors, illiquidity is something to embrace, as nurturing an investment away from public markets can reduce volatility and drive up rates of return. At Julius Baer, we think private equity investments have a part to play in a portfolio, as long as they are held alongside other diverse assets, including liquid equity and debt securities.

Here are five things that prospective investors might want to think about when balancing issues of liquidity and illiquidity in their decision.

Consideration 1: Do I want my entire portfolio to be exposed to public market volatility?

The world’s most liquid investments, where traders can move in and out of their positions in seconds, include the markets for oil, foreign currencies and equities listed on international stock exchanges. They are liquid, not only because they are large and fast moving, but also because they are popular among investors keen to make quick profits or respond to economic developments and changes in the fortunes of public companies. But that means they can be extremely volatile, fluctuating sharply in response to specific events or changes in wider investor sentiment.

Commodities and currencies react to macroeconomic data and equities tend to move in response to short-term variations in a company’s performance. Dealers might be able to buy and sell quickly, but prices can quickly move against them. Always keep in mind that in during times of market stress, liquidity can evaporate very fast. We believe that private equity can be a valuable tool, but should only be held by sophisticated investors as part of a diversified portfolio that contains other styles. 

Consideration 2: Can I commit to a long-term investment?

Investments in privately owned companies or projects tend to be slower moving and less widely held, so therefore more illiquid. Private equity investing takes a variety of forms, from the provision of funds to start-ups, early-stage or growth companies to sometimes extremely large leveraged buyouts involving acquisitions of public companies.

Not only do private equity investors undertake lengthy research, or due diligence, before committing capital, but they also tend to stay invested for relatively long periods, of at least three years and sometimes more than a decade. While it is true that the nature of this investment style means that it is often less easy for buyers and sellers to switch in and out of their positions, there are considerable benefits. By backing a company at an early stage of its development, investors can often invest on very attractive terms. Holding an investment longer term, especially one that is shielded from the volatility of daily trading, can also lead to better returns. The evidence suggests that private investments outperform public markets over time.

Consideration 3: Do I have an exit strategy?

Private equity investments are not static. Because the market has developed considerably since it first came to prominence more than 30 years ago, there is an established ‘secondary market’, where other investors buy and sell existing private investments.

Let us also not forget that private equity investors are temporary owners; they will have an exit strategy and aim for the right moment to sell, either to realise profits or free up capital to invest elsewhere. In short, just because an investment is privately held does not mean it is necessarily illiquid.

Consideration 4: Am I investing in a suitable fund structure?

The way an investment is structured has a big bearing on liquidity. With an ‘open-ended’ vehicle, where new shares or units are issued or redeemed in response to demand, sales by other investors can depress the value of a portfolio, while also triggering forced asset sales by the manager in order to meet redemption requests.

In falling markets, the liquidity of the underlying assets will reduce. This can lead to financial distress within the portfolio. With a ‘closed-end’ fund, share capital is ‘closed-ended’. Portfolio redemptions occur when an asset within the portfolio is sold by the manager and the capital is returned to investors via a cash distribution. Howeve,r if a fund participation is sold to a professional Secondary buyer only the ownership changes hands. It does not trigger forced selling by the manager. Therefore the portfolio valuation is not disturbed.

Most private equity investment firms use the closed-end model and also place restrictions on investors’ ability to leave, further reducing risks.

Consideration 5: Do I want to broaden my investment horizon?

The private equity industry offers investors a wide variety of investment options, from company inceptions to the turning around of mature companies in distress, and every stage of company development in between. Private capital can flow into assets and businesses to which public capital does not have access to. By including private assets in one’s investment strategy, one can expand the investment choice and diversify an investment portfolio.

Conclusion for investors

To be, or not to be, illiquid? It is true that private equity investments tend to be more illiquid than other assets. On the other hand, they can be less volatile than highly liquid assets and tend to outperform them over time. Put simply, illiquidity has its benefits. Today private assets have never been more accessible. We recommend our clients to own both public and private assets.

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