In a world of low interest rates, the temptation is high to lock up your money for an extended period of time and get rewarded for giving up liquidity. Great examples are the purchasing of private equity funds, or some other type of closed-ended investment structure that doesn’t allow you to redeem your capital for a period of say 5 or even 10 years and more. The return promises are usually in excess of 10% per annum.
But is this really worth it and is the return promise high enough to induce taking on such risk? To answer this question, we have looked at the so-called illiquidity premium in more detail. At the very basic level, we can look at the interest rate curve of most developed countries to clearly see the difference in yield as maturities increase in years. Being a bit generous, we can probably see a difference of 3% in premium between short and long term interest rates.
This means that any investment that requires us to lock up our money for an extended period of time, would have to at least offer this premium compared to other more liquid investments. Applying this formula to the private and public equity markets and assuming an average annual return of 7% for the latter, would mean that an investment would have to yield at least 10% in the former. But is this the whole story?
The fees for investing in private versus public equities are also vastly different. Investing in public equities will cost about 0.10%, while investing in a private equity fund would typically cost 2% in management and 20% performance fees. Given the expected returns for a private equity fund of 10% or more, this would result in an approximate annual fee of 4%. This also means that potentially half of your investment has gone to pay the fund manager over a typical 10 year horizon, before any returns (or losses) are even taken into consideration; but that’s another issue. Adding this together implies that at the source (gross of all fees), the companies that private equity funds invest in must therefore return at least double the performance of the public companies (3%+4% > 7%).
Is the performance of a company really twice as good with a private versus a public owner? We would argue that there really is no difference, and why should there be? The investment is into a company that does well at producing and selling products, the ownership is irrelevant. You could make an argument that private equity investments tend to be into smaller or higher growth companies, but you can also find that in the public markets. Ultimately, whether privately or publicly owned, profits from an investment are only realised when they are sold. And therein lies the conundrum. If you hold a publicly traded equity, you can sell whenever you want. In a private equity fund, you can’t. And that option is therefore also worth something.
We can apply the same type of thinking to any other asset classes, structures and products. The fact is, tying up your money for the long term can be a very expensive and risky endeavour. Make sure you get paid for it.