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A growing number of investors are looking to private assets to provide higher yields than liquid alternatives, but few are targeting illiquidity premia explicitly, writes John Dewey
Although trends in asset market returns have been generally positive since the global financial crisis, this trend could reverse as economies normalise and the era of extraordinary monetary easing ends. With fundamentals likely to once again drive asset prices, it might prove a challenging period for pension schemes, insurers and other long-term investors; many of whom are stretched to meet their return requirements through traditional investment strategies.
Already, more are turning to private assets – including infrastructure debt, private corporate debt, commercial real estate, structured finance and unlevered infrastructure – as alternatives to assets listed and traded on public markets.
A key driver for this is the higher expected returns that might be achieved from private assets over publicly-traded ones of broadly similar credit quality, in addition to other benefits they can provide such as diversification and downside protection. The yield uplift is loosely known as the illiquidity premium, which research suggests is available across a range of assets.
Strictly speaking, any premium from investing in alternatives may not reflect a reward purely for additional illiquidity risk.
Other factors may also drive the premium, including complexity and regulatory treatment, both of which might affect an asset’s relative appeal. The ability to source, analyse and structure complex assets without access to public research are often key requirements for successfully generating illiquidity premia for investors.
Whatever the case, investors in alternatives need to accept a degree of illiquidity. Given their private and idiosyncratic nature, it may be difficult to find alternative buyers during their lifetime without a meaningful reduction in value. For this reason, once invested, most will seek to reap the benefits of the premia and hold assets to maturity.
Measuring illiquidity premia
The first challenge for those seeking insights into illiquidity premia is to understand their scale. This is not necessarily straightforward, as most alternative assets do not have a close parallel in public markets. Nevertheless, a pragmatic approach to valuations can give a deeper understanding of how an asset is expected to perform, both in absolute terms and relative to other assets.
One way to do this is to compare private deals to a public benchmark, adjusting each deal spread to give a reasonable comparison with the benchmark’s characteristics. Adjustments can be derived from data sets of spreads on corporate non-financial bonds with different ratings profiles. Typically, the publicly-traded asset used as a comparator is not as liquid as risk-free assets and may itself provide some reward for illiquidity.
In infrastructure debt, for instance, the process might mean assessing rated and unrated euro and sterling deals from private issuers against an appropriate benchmark. It might be necessary to make adjustments for credit ratings and expected recovery rates if those metrics are not aligned with liquid benchmarks.
Drilling down in this way reveals a range of illiquidity premia in different asset classes. While these can have a direct impact on returns, they are rarely targeted directly by investors. In infrastructure debt, for example, our analysis of European private transactions showed illiquidity premia varying between 50 and 200 basis points between 2005 and early 2017, as illustrated by the light blue trend line in figure 1.
Premia fell in the financial crisis, as credit spreads widened in public markets, before increasing again as private asset pricing adjusted. And while the recent trend has been for illiquidity premia to narrow, they now appear to have stabilised and significant opportunities persist.
Sensitivity to public markets
Monitoring a range of illiquid assets reveals how their sensitivity to public markets varies. Private corporate debt, for example, tends to adjust faster to spread changes in public markets than infrastructure debt due to its shorter investment cycle. Although private assets may offer attractive returns relative to traditional listed assets, they are not immune to factors that influence yield dynamics in public markets, or supplydemand imbalances.
This highlights the need to take a flexible approach to constructing portfolios; looking across the premia available to identify opportunities that can collectively contribute to meeting investors’ long-term requirements. It could mean monitoring and investing in multiple markets simultaneously.
Given that each asset type has diverse drivers of return, and that corresponding listed markets also move largely independently, illiquidity premia opportunities can be volatile. Analysing each transaction in detail is the only way to understand opportunities and help investors meet their objectives, while keeping a carefully-calibrated tolerance for illiquidity in mind. A well-established network, significant expertise and a depth of resources are needed to identify and exploit opportunities as they arise.
Figure 1: Expectations of how investment will change in the next three years
- Significant dispersion of illiquidity premia across individual transactions
- Few investors explicitly assess and target illquidity premia
- Broad trends can be inferred from trend lines
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Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 31 August 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.
This is an edited version of an article in AIQ, Aviva Investors’ quarterly publication on the biggest themes in the global investment markets.