Arbitraging Liquidity: Understanding the Liquidity Premium

When private stocks go public, they can unlock value for their owners by eliminating what is known as a liquidity premium. Investopedia defines liquidity premium as:

…additional value demanded by investors when any given security cannot be easily and efficiently sold or otherwise converted into cash for its fair market value. When the liquidity premium is high, the asset is said to be illiquid. Investors of illiquid assets require compensation for the added risk of investing their funds in assets that may not be able to be sold for an extended period, especially since valuations can fluctuate with market effects in the interim.

In other words, there is value in being able to exit an investment at any moment. When an investment moves from being hard-to-sell to easy-to-sell, value may be unlocked for the holders who were willing to take on the risk of not being able to sell their investments as easily. A very common example of this typically happens when a stock goes public.

Another example of value being unlocked to generate a liquidity premium comes from Michael Milken, who essentially created the high yield debt market. His innovation, which may seem trivial today, was to create and trade bonds that other firms would not. He created liquidity where there was none before.

As stated previously, a very common way to unlock the liquidity premium of private stock is through an IPO.

Meanwhile, many private start-ups are going public later than ever, meaning that venture capitalists and later-stage growth investors have an opportunity to capture more upside than before.

Part of the reason for companies staying private longer is an influx of money into venture capital funds and growth funds themselves. As illustrated by Crunchbase, below, more and more money is moving into the space.

View our blog on venture vs growth equity.

Global Venture Dollar Volume 2011 to 2020

Another reason companies are going public later may be due to the fact that private companies can grow their shareholder base larger than before without having to list their shares. US News & World Report states:

“It used to be that once private companies hit 500 shareholders (including employees), they were forced by law to go public. That changed in 2012 with the signing of the JOBS Act, which raised that number to 2,000.”

While this does not mean that share prices of private companies cannot continue to grow once they go public, it does typically mean that low-hanging fruit is raised higher and higher up the tree as the lower branches are picked over before retail investors ever have a chance.

It is also important to note that companies would not have the choice to stay private for longer if there was not capital facilitating their ability to do so.

Public markets are known for their unemotional efficiency. Private markets, due to their illiquid nature, operate more inefficiently, which is what creates the opportunity set.

For a long time, the liquidity premium was used as a crutch to earn returns by mediocre funds. With increasing capital flowing into the growth equity space, it is important that investors partner with reputable managers who can win deal flow in an increasingly competitive marketplace.

Growth funds deploy capital into start-ups at higher valuations than their earlier stage venture peers because they are investing at a later stage in the company’s life cycle. In a sense, they are able to do this while seeking high returns because they are still earning a liquidity premium from the companies they are investing in. While growth equity funds may not see the same outsized returns as the earliest investors, they are also taking less risk.

Take the example of Uber. An investor who purchased Uber shares at a $1 billion or $10 billion valuation certainly did not make as much money as the earliest investors who seeded the enterprise and took it from nothing to unicorn status. However, at this higher valuation range, Uber was already a proven concept that consumers loved. While the business was not yet profitable, the business’ risk of failure was largely mitigated at this point in its life cycle.

However, private equity funds can offer more value to companies than just a checkbook. Due to the influx of capital into the growth equity space, fund managers who can offer operational guidance and expertise are poised to win deal flow.

The liquidity premium is not unique to start-ups. More standard private equity funds have been taking advantage of this source of returns for years and still do today.

Clifford Asness of AQR Capital Management has pointed out that this is precisely what private equity is paid to do.

Cliff then goes on to muse that there is a little-known benefit to investing in PE funds. PE funds post smoother returns because their assets are not liquid and thus there is no definitive price that their assets would be marked at. Although investors have to face extended lock-up periods, there is a potential trade-off for this type of return stream in the end.

So, while private equity funds may assume many of the same systemic risks as other long equity investors, there may actually be a psychological benefit to the lack of liquidity. Perhaps the smooth nature of the returns is why some are able to utilize leverage so effectively. Bloomberg writes:

A few things make PE different from other kinds of investing. First is the leverage. Acquisitions are typically financed with a lot of debt that ends up being owed by the acquired company. That means the PE firm and its investors can put in a comparatively small amount of cash, magnifying gains if they sell at a profit.

This is an added incentive to capture the liquidity premium. Call it ‘psychological alpha’, if you will.

While Cliff of AQR likes to compare private equity to leveraged long small caps, it’s important to emphasize the non-recourse nature of investing in private equity as well as the ability of large to access cheap capital with extended durations.

Schroder’s breaks it down succinctly: “An illiquidity premium does appear to exist for some alternative asset classes (in particular property). In addition, being able to stomach a degree of illiquidity enables pension schemes to access a wider opportunity set.”

As the graphic below shows, private equity and venture capital have historically benefitted.

Average Asset Returns Vs Illiquidity Estimates

While it may be hard to stomach not touching your money for an extended period, that’s ultimately why it pays off for some investors.

Why should pension funds be the only investors accessing this opportunity set?