The Paradox of Illiquidity—Expanding Investors’ View of Diversification
The “illiquidity premium” is a well-known financial concept. Defined simply, this is the premium investors receive in compensation for an asset that is not easily convertible into cash and to its fair market value.1 To avoid illiquidity, some investors and their advisors spend countless hours trying to identify the right mix of liquid asset classes that might capture upside or excess returns through the benefit of diversification. While diversification is good, left to itself, its effect on lifting portfolio performance may still be limited. Sophisticated investors have learned that the right balance of liquid and illiquid strategies may capture not only the diversification benefit, but also the coveted illiquidity premium.
The challenge of capturing the illiquidity premium is best articulated from two perspectives: that of the investor as well as the manager. Although both share a common interest, they are also in direct opposition. Allow me to explain.
While investors may be enticed by the potentially higher returns that may be realized through illiquid strategies, they also insist on liquidity. Behavioral finance and real-world experience corroborate the long history of investors doing the wrong thing at the wrong time. They routinely demand liquidity from their illiquid investments—usually in periods of falling prices and reduced ability to market their illiquid investments at a fair value. This conundrum has plagued the hedge fund and real estate industries for decades. Investment managers are presented with redemptions at the worst possible times and, although many investors understand that these actions can be counterproductive, they nevertheless demand it. Fund managers who attempt to mitigate irrational redemptions by discontinuing their liquidity programs run the risk of frustrating their investors. Compounding this issue is the circumstance that the manager is usually forced to sell the fund’s most liquid assets at fire sale prices to meet these early redemptions, which can permanently undercut the fund’s future growth opportunities.
Conversely, investment managers know that if they remain disciplined and patient, they can not only weather market storms, but can also deploy capital to accretive advantage during times of market distress. One such manager is Bill Ackman, Founder and CEO of Pershing Square Capital Management LP,2 who credits the success of his hedge fund to a permanent capital vehicle listed on a European exchange. This closed-end fund allows his fund to invest with a long-term perspective knowing that the capital source is permanent. This allows the manager to not only capture the illiquidity premium, but—just as importantly—to deploy capital into distress. This is where great managers can generate alpha or excess returns.3
Closed-end funds (CEFs) offer another approach to capturing the illiquidity premium. CEFs are designed to actively manage investments during the “permanent capital,” or illiquidity stage, but also mitigate illiquidity by providing a well-defined exit strategy after the initial period of illiquidity. Upon the close of the offering, these funds typically target a liquidity event—usually by listing on a public exchange or liquidating the assets.
In Mr. Ackman’s example, he has elegantly blended the notion of a permanent capital base that allows the manager to capture both the illiquidity premium and capitalize on market distress, while also providing investors an avenue to regular liquidity through the exchange. What an innovative and powerful example of how to intersect the interests of managers and investors in the illiquid space. The closed-end fund may trade at a premium or discount to its NAV in the event of such behavioral finance issues, but that is a fair price for liquidity in my view. What is not compromised is the actual NAV of the illiquid assets, which can stay invested through any distress period and, in fact, can take advantage of that dynamic by deploying capital into such distress.
In a low-interest-rate environment, I believe financial advisors can find ways to help expand their clients’ definition of portfolio diversification, and more importantly, we can also apply this broadened definition of illiquidity. Understanding the strategic benefit of illiquid assets is vital to helping advisors improve the performance levels of their clients’ portfolios.
The ability to capture the illiquidity premium—either through deferred liquidity in a closed-end fund strategy or through permanent capital vehicles that simultaneously provide liquidity through an exchange—may give individual investors the confidence to participate in these specialized asset classes and investment strategies.
The latter approach certainly seems to work for Mr. Ackman and it may present another interesting solution in our endeavor to help advisors efficiently allocate capital for their investors.
1Investopedia.com, Investment Terms. http://www.investopedia.com/terms/l/liquiditypremium.asp.
2Provasi Capital Partners LP and Pershing Square Capital Management LP are separate companies and are not affiliated.
3“Permanent Capital: Perpetual Cash Machines,” Financial Times online. http://www.ft.com/intl/cms/s/0/0b6272c2-91ae-11e4-afd2-00144feabdc0.html?siteedition=intl#axzz3O3ZkqWKB, accessed February 2, 2015.
Provasi Capital Partners LP is not affiliated with Pershing Square Capital nor is this article a referral or recommendation for any of their products or services. This article is intended for your private use and is for informational purposes only. Provasi Capital Partners LP undertakes no obligation to update or supplement this information at any time or in any way. This article does not take into account the investment objectives or financial situation of any particular person or institution.
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