Introduction: The concept of the illiquidity premium is increasingly discussed in the context of private market investments. As investors search for higher returns, understanding this term can offer valuable insights into how certain asset classes function and why they may command higher yields.

Defining the Illiquidity Premium: At its core, the illiquidity premium refers to the additional return investors receive for holding assets that are not easily convertible to cash. Unlike publicly traded equities or government bonds, illiquid assets like private equity, real estate, or venture capital investments often require a long-term commitment. In exchange for locking up capital, investors demand compensation for the reduced flexibility and increased risk, which comes in the form of higher potential returns.

This premium reflects the opportunity cost of tying up funds and the difficulty of selling these assets quickly, especially during times of market volatility or economic uncertainty. Essentially, it’s the market’s way of pricing the inconvenience and potential risk associated with illiquidity.

Where is the Illiquidity Premium Found: The illiquidity premium is commonly associated with alternative investments, which are becoming an integral part of diversified portfolios. Examples include:

• Private Equity: Investing in privately held companies, often with long investment horizons, yields significant illiquidity premiums. These investments can be transformative but require patience.
• Real Estate: Certain types of property investments, particularly in commercial real estate or niche markets, are less liquid but can offer superior returns compared to traditional equity or debt markets.
• Infrastructure Projects: Long-term commitments to large-scale infrastructure—like data centres or renewable energy assets—are classic examples of investments where the illiquidity premium plays a role.
• Private Credit: Loans to businesses or individuals outside the traditional banking system often involve higher risks and are less liquid, thus commanding an illiquidity premium.

Why Does the Illiquidity Premium Exist: The illiquidity premium exists because of the risk-return trade-off inherent in financial markets. When investors allocate funds to illiquid assets, they face several potential challenges:

• Inability to Access Cash: Unlike publicly traded shares, these investments cannot be sold quickly.
• Valuation Uncertainty: Illiquid assets lack daily market pricing, which can make their valuations less transparent.
• Market Timing Risks: Selling an illiquid asset may coincide with unfavourable market conditions, potentially impacting returns.
• Investors are therefore compensated for accepting these risks, and this compensation manifests as the illiquidity premium.

Benefits of the Illiquidity Premium: While the illiquidity premium may pose risks, it also presents opportunities for investors willing to take a long-term view. Some of the key benefits include:

• Enhanced Returns: Illiquid assets often outperform their liquid counterparts over time, rewarding patient investors.
• Portfolio Diversification: Including illiquid assets in a portfolio can reduce volatility, as these investments are less correlated with traditional asset classes like equities or bonds.
• Inflation Protection: Certain illiquid assets, such as real estate and infrastructure, provide a hedge against inflation.

Who Should Consider Illiquid Investments: Illiquid investments are not suitable for everyone. They require a well-thought-out strategy and a clear understanding of one’s risk tolerance and investment horizon. Typically, these assets are most appropriate for:

• High-Net-Worth Individuals (HNWIs) and institutional investors with the ability to lock up funds for extended periods.
• Investors seeking diversification beyond traditional asset classes.
• Those who have a long-term investment outlook and are comfortable with less frequent performance updates.

Final Thoughts: The illiquidity premium is a key driver of returns in private markets, rewarding investors who can accept the constraints of long-term, less liquid investments. By carefully assessing your portfolio’s goals and risk tolerance, you can determine whether illiquid assets and their associated premiums align with your financial objectives.

Courtesy of Ben Rockell, Caravel Partners Group Sales Director and Managing Partner of Kingsbury & Partners https://kingsburyandpartners.ae