The return advantages of private assets have often been chalked up to just their lower liquidity. We believe this view must evolve to include understanding the “complexity premium”.
The “illiquidity premium” has long dominated conversations about returns in private assets. But while it remains important, we think investor understanding of private markets returns should evolve. In the coming weeks, we will be exploring the concept of “complexity premium” in a series of articles.
The concept of the illiquidity premium is appealing in its simplicity. Private assets typically have holding periods of several years or more. Illiquidity is often seen as a disadvantage compared to liquid investments; therefore, the investor is compensated by a performance premium.
But there are problems with the view.
The first is the view that illiquidity is inherently a risk. The second is that as private assets grow in popularity, private asset liquidity is generally rising. If illiquidity were all private markets had to offer, it would suggest their appeal would dwindle as allocations rise, which we strongly refute.
In this series of articles, we intend to challenge the traditional view of the illiquidity premium and, more importantly, encourage investors to adopt a broader appreciation of the benefits of private markets. Indeed, we argue that a large proportion of private assets returns are generated by the convergence of a unique situation or opportunity and a corresponding skillset. This is the complexity premium.
The idea of the illiquidity premium implies that unless investors are paid for accepting illiquidity, they would not do so. However, expected outperformance is not the only benefit that private assets provide. There is also a lower actual volatility, diversification opportunities and the possibility to achieve sustainability and impact targets.
Furthermore, if liabilities are managed/matched, as is the case for many institutional investors, the lack of interim liquidity may not be a problem at all.
When investing in private assets, illiquidity is a certainty. In addition to the typical multi-year investment holding periods, there are carefully designed fund or mandate structures with fund lives of 8-12 years that lock up capital for the long-term. Private assets investors accept illiquidity not as a risk but as a choice.
What’s more, for the private asset managers managing the capital - and their investors – that illiquidity becomes an opportunity. Illiquidity allows them to be more patient and selective in deal sourcing and exit management. It also creates time to develop the assets in their portfolios.
The point here is that illiquidity is not necessarily a bad thing. Moreover, illiquidity is not the only driver of excess returns in private markets. The strong rise in interest in private markets means these markets are much larger, and much more liquid today than they were in the past, and yet outperformance persists. The appetite for private asset investments continues to grow. Their appeal extends far beyond an additional return for a longer lock-up period.
If there is outperformance in a private asset strategy or in a single investment, the standard explanation would be that investors have taken on more risk (in the form of illiquidity or other risks). The higher risk leads to lower entry valuations and thus to better performance; the compensation for the risks taken.
In this theoretical model, whether the risk materialises or not is explained by statistics. However, numerous real life investment examples make clear that the difference in performance delivered by private assets cannot only by explained by luck and random events. Instead, it is to a large degree decided by skill advantages that some managers have over others. A more appropriate description is to explain private asset returns as a combination of risk factors and skills advantages.
Skill differences are generally more pronounced in private assets than for listed investments, as access to investments and information is generally much more limited. Investors also take a much more active role in sourcing, accessing, negotiating, transforming and exiting an investment on the private asset side. Within private assets, skill differences become especially pronounced in what we call the “long tail” of investment opportunities – the vast majority of transactions have smaller deal sizes and are sourced in less efficient markets.
In our view, return premia can be captured in private assets when two factors meet.
The nature of the complexity premium differs depending on the type of asset, but both of these things are needed for it to emerge. A complex situation without the appropriate skills to engage with it successfully cannot offer the possibility to capture a complexity premium.
The below graphic breaks down different sources of the complexity premium along the investment process. They describe complexities of a private asset investment that can contribute to value generation if matched by the appropriate skills.
No two investments are the same in how they might capture a complexity premium. We highlight two examples from different private asset classes to illustrate the concept, and how a complexity premium might be captured in different ways.
Let’s take an example from our private equity team. It sourced a co-investment opportunity in a residential care home through a close primary investment relationship and selected it based on prior experience with a similar business model. The fund manager demonstrated specialist skills in developing the company, by further improving the quality of care, which benefited all patients and increased revenues. This was achieved by among other things, better utilisation and the opening of additional care facilities. This ultimately laid the ground for a successful exit. None of these drivers of complexity premium relate to liquidity.
In another example, our real estate team had identified an opportunity with a distressed seller to acquire an office building in the Old Street area of London. This is an area they expected to rise in attractiveness for tenants from the tech sector. The team initiated extensive refurbishment work - including improving the building’s energy efficiency - and pre-let most of the building to two growing tech and marketing companies before construction was completed. The Old Street area of London has emerged as a growing tech hub and has, accordingly, attracted increased investor interest.
This is another example how the value creation process creates illiquidity, not the other way round.
In the coming weeks, we will be releasing a series of articles detailing how complexity premium works in a number of private asset types. From the numerous private equity deal types, to infrastructure (debt and equity), real estate (debt and equity) and beyond, we will delve into the many ways investor returns are delivered in private assets.