The return advantages of private assets have been chalked up to lower liquidity. Nils Rode, CIO at Schroders Capital, says this simple view must evolve to include an understanding of the ‘complexity premium’
The return advantages of private assets have been chalked up to lower liquidity. Nils Rode, CIO at Schroders Capital, says this simple view must evolve to include an understanding of the ‘complexity premium’
The ‘illiquidity premium’ is synonymous with private assets. While it remains important, investor understanding of private market returns should evolve to include the ‘complexity premium.’
The illiquidity premium is appealing in its simplicity. Private assets typically have holding periods of several years or more and illiquidity is often seen as a disadvantage. Therefore, the investor is compensated by a performance premium. But there are problems with the view.
The first is the view that illiquidity is inherently a risk. The second is that as private assets grow in popularity, liquidity is rising. If illiquidity were all private markets had to offer, it would suggest their appeal would dwindle as allocations rise, which we strongly refute.
We challenge the traditional view of the illiquidity premium and, more importantly, encourage investors to adopt a broader appreciation of the benefits of private markets. Indeed, we argue that a large proportion of private asset returns are generated by the convergence of a unique situation or opportunity and a corresponding skillset. This is the complexity premium.
Should Investors Be Paid to Invest in Private Assets?
The idea of the illiquidity premium implies that unless investors are paid for accepting illiquidity, they would not do so. However, expected outperformance is not the only benefit of private assets. There is also a lower actual volatility, as well as diversification opportunities and the possibility of achieving sustainability and impact targets.
Furthermore, if liabilities are managed/matched, as is the case for many institutional investors, the availability of interim liquidity may not be a problem at all.
In Private Assets, Illiquidity Is a Choice, Not a Risk
When investing in private assets, illiquidity is a certainty. In addition to the typical multi-year investment holding periods, there are carefully designed fund or mandate structures with fund lives of 8-12 years that lock up capital. Private asset investors accept illiquidity not as a risk but as a choice.
What’s more, for the private asset managers managing the capital – and their investors – that illiquidity becomes an opportunity. Illiquidity allows them to be more patient and selective in deal-sourcing and exit management. It creates time to develop the assets in their portfolios.
The point here is that illiquidity is not necessarily a bad thing. Moreover, illiquidity is not the only driver of excess returns in private markets. The strong rise in interest in private markets means these markets are much larger, and much more liquid today than they were in the past, and yet outperformance persists and appetite for private asset investment continues to grow. The appeal extends far beyond an additional return for a longer lock-up period.
Is There a Risk Premium or a Skill Premium?
If there is outperformance in a private asset strategy or investment, the standard explanation is that investors have taken on more risk (in the form of illiquidity or other risks). The higher risk leads to lower entry valuations and thus to better performance – the compensation for the risks taken.
In this theoretical model, whether the risk materializes or not is explained by statistics. Numerous real life investment examples make clear that the difference in performance delivered by private assets cannot only by explained by luck and random events. Instead, it is to a large degree decided by skill advantages that some managers have over others. A more appropriate description is to explain private asset returns as a combination of risk factors and skills advantages.
Skill differences are generally more pronounced in private assets than in listed investments, as access to investments and information is much more limited. Investors also take a much more active role in sourcing, accessing, negotiating, transforming, and exiting an investment. Within private assets, skill differences become especially pronounced in what we call the ‘long tail’ of opportunities – the smaller deals sourced in less efficient markets that make up the vast majority of investments.
Embrace the Complexity Premium
In our view, return premia can be captured in private assets when two factors meet:
The nature of the complexity premium differs depending on the type of asset, but both of these things are needed for it to emerge. A complex situation without the appropriate skills to engage with it cannot offer the possibility of capturing a complexity premium.
Sources of Private Asset Complexity Premium
Complexities of a private asset investment can contribute to value generation if matched by the appropriate skills at all stages of the investment lifecycle, from sourcing and access to selection and execution, transformation, and exit. No two investments capture a complexity premium in the same way.
Let’s take an example from our private equity team. It sourced a co-investment opportunity in a residential care home through a close primary investment relationship and selected it based on prior experience with a similar business model. The fund manager demonstrated specialist skills in developing the company, improving the quality of care, which benefited all patients and increased revenues. This ultimately laid the groundwork for a successful exit. None of these drivers of complexity premium relates to liquidity.
In another example, our real estate team identified an opportunity with a distressed seller to acquire an office building in the Old Street area of London, an area they expected to rise in attractiveness for tenants from the tech sector. The team initiated extensive refurbishment work and pre-let most of the building to two growing tech and marketing companies before construction was completed.
These examples show how the value creation process creates illiquidity, not the other way round. In private capital, complexity is to be embraced and captured.
About Nils Rode
Nils Rode is Chief Investment Officer at Schroders Capital. He joined Schroders Group in 2005 and is based in Zurich. Before joining Schroders Capital, Nils worked at SkyOnline and McKinsey & Company. Nils wrote a book on strategic management of knowledge-based businesses, holds an MBA from ESCP Europe, a PhD in Economics, and a Specialisation Certificate in Data Science. This article is one of a series he has written on the complexity premium in alternatives.
About Schroders
Schroders Capital is the private markets investment division of Schroders Group. With $65bn AUM and 498 employees, it covers a broad range of asset classes out of 19 offices globally.
This article originally appeared in the Preqin Markets in Focus: Alternative Assets in Europe report. The opinions and facts included within the above do not constitute investment advice. Professional advice should be sought before making any investment or other decisions. Preqin and Schroders providing the information in this content accept no liability for any decisions taken in relation to the above.