Abstract
Institutional investors expect a return premium for illiquidity when an investment is private and cannot be sold easily in an established liquid market. For investors that have a very long investment horizon—and some might argue a permanent (or perpetual) investment portfolio—investments in private markets with any such level of expected return premium might seem to be dominant to a “liquid markets only” construct. However, how much should this premium be? The author hypothesizes that the illiquidity premium observed is directly related to the risk-equivalent liquid markets diversification-rebalancing returns forgone in pursuing illiquid investments. The author posits the excess return to illiquidity available to the long-term, non-liquidity constrained investor, is an investor-specific opportunity cost of illiquidity, and by logical extension, he proposes, an (efficient) market “opportunity cost to illiquidity” hypothesis. Finally, he examines the private equity industry benchmarking convention for performance evaluation—large-cap stocks + 300 bps—under this paradigm. <b>TOPICS:</b>Real assets/alternative investments/private equity, analysis of individual factors/risk premia, performance measurement
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