Liquidity is the ability to convert an asset into cash quickly and without a substantial discount. In other words, it's how easy it is to sell an asset. Stock markets like the New York Stock Exchange are considered highly liquid because shares of most publicly traded companies can be bought or sold rapidly and at close to their true value.
With hundreds of billions of dollars in daily trading volume, NYSE’s buyers and sellers can be sure to find each other and complete transactions quickly. Private markets, on the other hand, are much less liquid.
Why are private markets illiquid?
Private market investments often come with a "lock-up" period, meaning that investors are unable to sell their shares for a certain amount of time. While venture funds can have a hold period of up to ten years, disbursements can begin as early as year five or six, with VC-backed companies going public on average 5.3 years after securing their first investment.
This lack of liquidity can be frustrating for investors who want to cash out their investments sooner. But it's important to remember that illiquidity is often the price of admission for higher returns.
According to detailed research by Cambridge Associates, the average annual return for top-quartile VC funds over the past 10 years ranged from 15% to 27%. In contrast, the S&P500 returned under 10 percent over the same time period.
So, while you may have to wait longer to sell your shares in a private company, you're likely to see a higher return on your investment when you do eventually cash out.
What is the illiquidity premium?
The illiquidity premium is the higher return that investors expect to earn for investing in an illiquid asset. This risk premium compensates investors for the inconvenience and added risk of not being able to sell their investment quickly if they need to.
For example, let's say you invest $1,000 in a stock that pays a 5 percent annual dividend. After one year, you'll have earned $50 in dividends and your investment will be worth $1,050.
Now let's say you invest the same $1,000 in a private company that doesn't pay dividends but is expected to go public in five years. Suppose the company's IPO is highly successful, and you sell your shares for $2,000, earning a 100 percent return on your investment.
However, there's also a chance that the company might not go public or that its shares will be worth less than you paid when it does finally list on an exchange. So there's more risk involved in this investment than there was with the stock that paid dividends.
To compensate you for this additional risk, venture capitalists typically expect to earn a higher return on their investments than they would from stocks or other kinds of investments.
Private market liquidity is increasing
Despite the common perception that private markets are illiquid, there have been some recent changes that are making it easier for investors to cash out their investments sooner.
One of the most notable developments is the rise of secondary markets, which provide a way for investors to sell their shares in private companies before they go public.
According to a report by Common Fund, secondary transaction volume in the first half of 2021 increased to $48 billion, compared to the first half of 2020 volume of $18 billion. This trend is likely to continue as more and more investors look for ways to cash out of their illiquid investments sooner.
The bottom line
Private market liquidity is often misunderstood. While it's true that these investments can be less liquid than stocks or other kinds of assets, there are some recent developments that are making it easier for investors to cash out sooner. And, despite the added risk, these investments can still offer attractive returns.
With Gridline, you can get the best of both worlds: professionally managed alternative investment funds with lower capital minimums, transparent fees, and greater liquidity.