Getting paid for illiquidity

If you follow financial matters and sometimes talk about this subject with others, one sentence you might have heard in the last 5-10 years was: “How can you make money when the interest in the bank is zero?” This resigned, cynical statement has surprisingly been quite widespread both among financial laymen and investment professionals. The paradox is that this ended up being a period of a sustained bull market where most asset classes performed well – precisely because central banks and policy makers succeeded in their attempt to reflate financial markets by forcing investors to shift their assets into the financial markets through the minimal interest rate policy.

With markets at historic highs following years of bull market the pessimists will quickly conclude that all investors are doomed to choose between two evils: safe investments which are yielding little on one side or higher yielding investments which are bound to crash on the other side.

Is this point of view making any sense? The fact of the matter is that it does – for those whose financial perspectives and portfolios remain limited to the traditional asset classes of bonds and stocks. Traditional safe-haven investments such as western sovereign bonds, high-quality corporate bonds and bank deposits indeed provide low to even negative interest rates. The S&P 500 has a P/E of 23.51 which corresponds to an earnings yield of 4.2% and the dividend yield is 2%. These ratios as well as a range of others indicate elevated valuations by historic standards. However they also have to be put in the perspective of the low interest rates and the low inflation - the key point bears have been missing all along the rally in risky assets. Bull markets tend to end up in euphoria and with extreme valuations and both are missing right now.

We will not make any prediction about what will happen in the short-term because we do not claim the ability to forecast the future (and we do not know of anyone in history who has been able to reliably predict short-term market developments). What is clear however is that the risk-reward of the stock markets is not currently particularly appealing. There is a risk of significant downside in the short to middle terms and the current valuation levels imply that future returns should be below historic averages and that a 5% annual return in the next 5-10 years is probably rather optimistic. So at this stage those limited to bonds and equities are really between a rock and a hard place.

However, we have often made the point that there is a wide financial world out there that offers interesting niche investment opportunities with limited market correlation and attractive risk-reward. We have often talked about such opportunities and we will not detail them again here. Rather, at a higher level, we would like to focus on what we believe to be today’s elephant in the room: the illiquidity premium.

The illiquidity premium is the additional return investors sometimes require to hold onto illiquid investments which cannot easily be traded on a public market. It is not possible to size the illiquidity premium as it depends on the asset class and evolves over time.

 

At present time we believe that several areas do provide a significant illiquidity premium. This includes in our view a certain number of unlisted credit investments which can provide net returns to investors in the 8-12% range while offering an appreciable degree of downside protection.

Infrastructure investments is another area that can offer appreciable returns assuming that one focuses on the right managers in the right niches which is critical in that field. Provided that this is the case, annual returns north of 10% are not unrealistic. A key aspect of infrastructure investing is that if they are implemented effectively they can offer a considerable degree of predictability and security as a good infrastructure fund manager will focus on projects where a strong counterparty such as a country commits in advance to make certain payments if the provider of the infrastructure delivers on its commitments – for example delivering a new toll-road at a certain time and operating it according to predefined requirements.

While many real estate markets are fully valued and possibly overvalued and bound for corrections there remain pockets of opportunity throughout the world. Here too competent operators can still find attractive projects offering double-digits returns with a 2-5 years time horizon. If these projects are financed appropriately they can offer the downside protection typical of a well-located building.

Looking at the big picture there appears to be a staggering contrast today between these illiquid opportunities and the more liquid, “plain vanilla” stocks and bonds opportunities. While a careful and well-diversified selection of some of the illiquid investments mentioned above has the potential to provide a net return of 10% or more with a 5-10 years perspective, we believe that the traditional stock and equity portfolios will likely be limited to low-single digit returns over the same period (although not necessarily in a linear way – we could have for example initially a continuation of today’s bullish trend and eventually a correction).

What is clear is that in today’s world you get paid nicely for illiquidity. While in the old-world of higher interest rates and more promising equity returns many investors refrained from looking at illiquid investments this mindset is starting to change. In five or ten years the cynics might well be looking back and wondering how they missed this opportunity!

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