Does the Liquidity Risk Premium Still Exist in Private Equity?

FRG has recently been investigating the dynamics of the private capital markets.  Our work has led us to a ground-breaking product designed to help allocators evaluate potential cash flows, risks, and plan future commitments to private capital.  You can learn more here and read about our modeling efforts in our white paper, “Macroeconomic Effects On The Modeling of Private Capital Cash Flows.”

As mentioned in a previous post, we are investigating the effects of available liquidity in the private capital market.  This leads to an obvious question: Does the Liquidity Risk Premium Still Exist in Private Equity?

It is assumed by most in the space that the answer is “Yes.”  Excess returns provided by private funds are attributable to reduced liquidity.  Lock up periods of 10+ years allow managers to find investments that would not be possible otherwise.  This premium is HIGHLY attractive in a world of low rates and cyclically high public equity valuations.  Where else can a pension or endowment find the rates of return required?

If the answer is, “No,” then Houston, we have a problem.  Money continues to flow into PE at a high rate.  A recent article in the FT (quoting data from FRG partner Preqin) show there is nearly $1.5 trillion in dry powder.  Factoring in leverage, there could be, in excess of, $5 trillion in capital waiting to be deployed.  In the case of a “No” answer, return chasing could have gone too far, too fast.

As mentioned, leverage in private capital funds is large and maybe growing larger.  If the liquidity risk premium has been bid away, what investors are left with may very well be just leveraged market risk.  What is assumed to be high alpha/low beta, might, in fact, be low alpha/high beta.  This has massive implications for asset allocation.

We are attempting to get our heads around this problem in order to help our clients understand the risk associated with their portfolios.

 

Dominic Pazzula is a Director with the Financial Risk Group specializing in asset allocation and risk management.  He has more than 15 years of experience evaluating risk at a portfolio level and managing asset allocation funds.  He is responsible for product design of FRG’s asset allocation software offerings and consults with clients helping to apply the latest technologies to solve their risk, reporting, and allocation challenges.

 

 

 

 

 

Private Equity and Debt Liquidity, the “Secondary” Market

A significant consideration in several aspects of Private Equity and Private Debt has been attributed to the liquidity (or lack thereof) of these investments.  The liquidity factor has been cited as a basic investment decision, influencing complex pricing, return of investment and financial risk management.  But as the environment has changed and matured, is liquidity being considered as it should be?

FRG’s ongoing research suggests that some of the changes this asset class are experiencing may be attributable to changes in the liquidity profile of these investments, which in turn may affect asset management decisions.  As modeling techniques continue to evolve in the asset management space, illustrated in our recent paper Macroeconomic Effects On The Modeling of Private Capital Cash Flows, their use as both an asset management tool and a risk management tool become more valuable.

The extreme importance placed on liquidity risk for all types of financial investments, and the financial community in general, to this point in time have been primarily associated with public investments.  However, a burgeoning “secondary” market in Private Equity and Private Debt will change the liquidity consideration of this asset class, a better understanding of which is necessary for investment managers active in this space.  Achieving this understanding will in turn provide private equity and private debt investment managers with another perspective with which to assess management decision aligning a bit more with that traditionally available for public investments. FRG is refining research into the liquidity of Private Capital investments through an appreciation of the dynamics of the environment to provide a better understanding of the behavior of these investments. Watch for more from us on this intriguing subject.

Read more about FRG’s work in Private Capital Forecasting via the VOR platform.

Dr. Jimmie Lenz is a Principal with the Financial Risk Group and teaches Finance at the University of South Carolina.  He has 30 years of experience in financial services, including roles as Chief Risk Officer, Chief Credit Officer, and Head of Predictive Analytics at one of the largest brokerage firms and Wealth Management groups in the U.S.

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