The rise of private markets has been supported by the perceived existence of an ‘illiquidity premium’ – or the extra return provided to investors as compensation for holding assets that are difficult to trade.

Although the concept has seemingly become commonly accepted, there is no clear definition of precisely what it is or how it comes about. At times it can feel as if it is simply some magic dust sprinkled on private assets to boost performance. Given the growing importance of this area, it feels worthwhile being a little more specific – so just what is the illiquidity premium?

Let’s return to the basic definition – investors demand a higher return for an asset that is hard to buy and sell. This makes sense – if I am going to lock my money away, I want some reward for the inflexibility. *

While this idea may seem reasonable, investors demanding an additional return does not make it so, and the above framing is still a little vague.  A better one might be:

The illiquidity premium is the additional return for holding an illiquid asset relative to a more liquid asset, other things being equal.

The ‘other things being equal’ part is important here. To isolate the illiquidity premium we need to say that if we had two identical assets but one was illiquid (private) and the other liquid (public), we should anticipate a higher return from the private asset.

The next question is – how do we get a higher return from the illiquid asset? It must be because it is cheaper than its liquid counterpart. If there is no difference in fundamentals, then there has to be a valuation discount to enhance my prospective return. How else could it come about?

There are, of course, other ways that additional performance may be garnered from illiquid, private market exposure – the opportunity set might be wider, there may be a benefit to private equity firms having control of a business and a private market manager may have a greater ability to add ‘alpha’. While all these elements may be valid, they are simply potential features of private market investing not an illiquidity premium.

If we define the illiquidity premium as being derived from a valuation gap between private and public assets, it tells us two things:

1) The premium should be in some way observable: Although we will never be able to observe the valuation of a private asset in a parallel universe where it is publicly listed , it should be possible to compare the valuations of similar assets in the public and private sphere, and ascertain whether there is a discount. (This is probably easier to analyse in private credit than private equity). If private assets of similar quality are priced more expensively – where is the illiquidity premium coming from?

2) The premium will be time varying: If the illiquidity premium is about the valuation gap between public and private assets then it will not be static, but will wax and wane based upon the prevailing environment. If private assets are in high demand, the illiquidity premium will be (at best) lower. We should not treat it as a permanent, structural advantage.

One of the primary drivers for the burgeoning demand for private assets has been the long-run return advantage relative to public markets (let’s leave the validity of this argument for another day). Part of this apparent edge is widely believed to have come from the illiquidity premium. We need to be careful, however, that what is being identified as an inevitable premium is not simply a significant valuation re-rating in private assets from a period where demand was far lower and access much more difficult.

There is a not insignificant risk that the clamour to capture an illiquidity premium acts to extinguish it.

The broader use of private assets will inevitably be a critical investment theme over the coming years. Given how consequential this area may be for investors, if we are to use coverall terms like ‘the illiquidity premium’ we need to be clear about precisely what we mean.

* From a behavioural perspective, there is a strong case that illiquidity improves ‘behaviour-adjusted’ returns by forcing us to be long-term investors and preventing us from following our worse impulses. Perhaps this is the real illiquidity premium.

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All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point.

This article was originally published by Behavioural Investment.