Paying For Illiquidity

One of the few boneheadedly obvious things financial theory tells us is that an asset is worth more if you can immediately convert it into cash. A CD maturing in a year is worth a discount to face value; an illiquid bond maturing in a decade is worth less; a minority shareholding in a small company is worth even less.

Fortunately for anyone who gets paid to explain this stuff for a living, the terminology is hopelessly confused. As one of my CFA workbooks pointed out, the two terms people use for the extra return investors demand in exchange for their money being locked up are “illiquidity premium” and “liquidity premium.” Nice.

This is especially confusing because there’s a certain category of investors who actually want illiquidity, and inasumch as investor preferences are expressed by the returns they accept, they’ll pay a premium for assets that are harder to sell. This flies in the face of financial theory, but the institutional logic behind it is sound — for the asset allocators, not the people they’re allocating on behalf of.

Achieving Superior Risk-Adjusted Returns by Being Bad at Adjusting for Risk

Private equity is a big business — PE funds raised around $700bn in 2018, and have about $2tr in capital available to invest. Historically, the industry has served a useful purpose: by raising managers’ equity stakes in a company, they incentivize better management, and since higher manager stakes correspond to bigger comp packages, they can…