The Illiquidity Premium
Many advisors and investors believe that the bull market is at its end. They have reduced return expectations for publicly traded assets over the next several years. So, to improve returns, many advisors and investors are looking to invest in private, illiquid assets (from which they expect higher returns) and, in doing so, harvest an illiquidity premium. Last November, Investment News ran a story titled “RIAs Leaning Toward Alternative Investments in 2018”. The article noted that, of the advisors they surveyed, many planned to increase exposure to private equity (37%), private credit (23%) and real estate (22%), all illiquid assets.
What Is Liquidity?
An accepted definition for the liquidity of an asset is: the time in which that asset can be converted to cash, without affecting the asset’s price. So, knowing an asset’s price is necessary to assess the asset’s liquidity. When there is not an established, active market for an asset, determining the asset’s price requires judgment. Accountants rely on the concept of “fair value”. U.S. Generally Accepted Accounting Principles (GAAP) describe fair value as the price that would be received to sell an asset or pay to transfer a liability in an orderly transaction between market participants. To standardize the definition of fair value, Financial Accounting Standards No. 157 (FAS 157) was created. FAS 157 requires disclosure as to the degree of certainty over the fair value assigned to an asset, according to a hierarchy of inputs used (see Table 1 below).
Table 1 – FAS 157 Fair Value Hierarchy
Input | Description |
Level 1 | observable, quoted prices for identical assets or liabilities in active markets |
Level 2 | significant other observable inputs, such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets in markets that are not active; and inputs other than quoted prices e.g. interest rates and yield curves |
Level 3 | significant unobservable inputs based on the best information available in the circumstances, to the extent observable inputs are not available, which may include assumptions made by persons responsible for determining the fair value |
While price is only one consideration, it’s a reasonable viewpoint that assets priced with Level 1 inputs are the most liquid, while assets priced with Level 2 and 3 inputs are successively less liquid. To the degree that any assets have been excluded from this categorization, the safest assumption is that such assets are the least liquid.
Products Intended to Harvest the Illiquidity Premium
Product sponsors have anticipated investors’ desire to harvest the illiquidity premium. Well known product sponsors have launched or begun to launch products investing in each of private equity, private credit and real estate asset classes. Given that the portfolios of these investment products contain illiquid assets, the products themselves are illiquid relative to a most assets (i.e. stocks, bonds, mutual funds and ETFs) held by individual investors. Some of the sponsored products are private, unregistered vehicles. As such, the details of those private products are not in the public domain. However, a number of illiquid products have been registered with the SEC. So, via filings available on the SEC’s EDGAR website (SEC.gov | Company Search Page), we can examine a few of these products to consider the relative level of liquidity that an investor may experience when trying to harvest the illiquidity premium.
Tables 2,3 and 4 below list a few of these Private, Credit and Real Estate products respectively, with recently available fair value information and their subscription (Sub.) and redemption (Red.) policies. Note: For these products, redemptions are generally effected via the repurchase by the fund of an investor’s shares.
Table 2 – Private Equity Products and Redemption Policies
Product | Staus | Registr. | Fair Value Hierarchy | Subs. | Reds. | ||||||||
CPG Carlyle Commitments Master Fund, LLC | 1st Notice of Exempt Offering of Securities filed 6/2013; NAV of $1,045M as of 12/31/17 | ’40 Act, Reg D. exempt, Accredited Investor only | $1,080M of Investments as of 12/31/17:
| Monthly | Repurchase offers at Board discretion; Nominally 5% within two years of request. | ||||||||
NB Crossroads IV (a master fund with 2 feeder funds, each for an investor segment) | 1st Notice of Exempt Offering of Securities filed 11/2016; NAV of $60M as of 12/31/17 | ’40 Act, Reg D. exempt, Accredited Investor & Qualified Client only | $60M of Investments as of 12/31/17:
| Ongoing commit-ments during the fund-raising period, drawn from investors as needed | None. Distributions in the latter stages of the fund’s expected 10-12 year life | ||||||||
NB Crossroads V (a master fund with 4 feeder funds) | No offering notice filed yet | as above | N/A, not yet operational | as above | as above | ||||||||
Goldman Sachs Private Markets Fund 2018 LLC (a master fund with 2 feeder funds) | Effective 3/2018 | ‘40 Act, ’33 Act, Accredited Investor only | N/A, not yet operational | as above | None. Distributions in the latter stages of the fund’s expected 11-16 year life |
Comparing the Liquidity Offered by These Products
Judging only by the Fair Value Hierarchy and redemption policies identified in Tables 2-4, of these products intended to harvest the illiquidity premium, the credit products are the most liquid and the private equity products the least liquid.
On the other hand, judging by the stated redemption terms, the real estate products (daily or monthly repurchases) appear to be more liquid than the credit products (quarterly repurchases). The greater repurchase frequency offered by these non-traded REITs vs. these ’40 Act Credit funds is likely due to two structural differences:
- Three of the four credit funds have quarterly repurchases as a “fundamental policy” (requiring a shareholder vote to change). In contrast, repurchases made by these non-traded REITs are at the discretion of their respective Boards. As such, those three credit funds have signaled a stronger intention of providing liquidity albeit less frequently than the non-trade REITs.
- REITs generally have access to greater leverage than ’40 Act funds. Thus, they may, under normal operating conditions, have more flexibility to fulfill redemptions via borrowed cash instead of selling underlying illiquid assets.
Table 3 – Credit Products and Redemption Policies
Product | Status | Registr. | Fair Value Hierarchy | Subs. | Reds. | ||||||
PIMCO Flexible Credit Income Fund | Registration eff. Feb. 2017; NAV of $278M as of 12/31/17 | ‘40 Act ’33 Act | $387M of Investments as of 12/31/17:
| Daily | Quarterly repurchase offers of 5% to 25% as a “fundamental policy” | ||||||
Partners Group Private Income Opportunities, LLC | Registration effective May 2017; NAV of $27M as of 12/31/17 | ‘40 Act, ’33 Act, Accredited Investor only | $22M of Investments as of 12/31/17:
| Monthly | Quarterly repurchase offers of 0% to 5% at Board discretion | ||||||
| FS Credit Income Fund | Registration effective Oct 2017; NAV of $21M as of 1/31/18 | ‘40 Act, ’33 Act | $25M of Investments as of 1/31/18:
| Daily | Quarterly repurchase offers of 5% to 25% as a “fundamental policy” | ||||||
| OFI Carlyle Global Private Credit Fund | In Registration | ‘40 Act, ’33 Act | N/A, fund not yet operational. | Monthly | Quarterly repurchase offers of 5% to 25% as a “fundamental policy” |
While the assets within private equity funds appear to be the most illiquid, the liquidity offered to an individual investor in one of these funds is more nuanced. The CPG Carlyle Commitments Master Fund is evergreen. This means that, throughout the fund’s life, investors can purchase and pay for shares at the then current NAV, have no requirement to contribute additional capital and can remain invested indefinitely or tender shares for repurchase. The other products in Table 2 follow the more traditional “vintage” approach used by private PE funds. They solicit commitments from investors during a fundraising phase, draw capital from the investors during an investment phase and distribute proceeds during a harvesting phase. Which approach provides an investor with more liquidity? The answer depends on many variables. Since, under the vintage approach, the investor has the use of their capital until called by the fund, and since all investor capital is distributed from asset sale proceeds during the harvesting phase, the vintage approach likely provides more liquidity both early and late in a vintage fund’s life, with effectively no liquidity in between. Whereas, an evergreen PE fund, such as the CPG Carlyle Commitments Master Fund, provides the investor with more consistent liquidity terms over the course of their investment.
Table 4 – Real Estate Products and Redemption Policies
Product | Status | Registr. | Fair Value Hierarchy | Subs. | Reds. | ||||||||
Blackstone Real Estate Income Trust, Inc | Effective 8/2016; $1.5B in shareholder equity as of 12/31/17 | Non Traded REIT Investor Income or net worth requirement. | $4.6B in assets as of 12/31/17
| Monthly | Monthly repurchase offers of 0% to 2% (max 5% per quarter) at Board discretion | ||||||||
FS Credit Real Estate Income Trust, Inc. | Effective 9/2017; $29M in shareholder equity as of 12/31/17 | As above | $53M in assets as of 12/31/17
| Daily | May be requested Daily (max 5% per quarter) at Board discretion; | ||||||||
Starwood Real Estate Income Trust, Inc | Effective 12/2017; | As above | N/A | Monthly | Monthly repurchase offers at Board discretion | ||||||||
Oaktree Real Estate Income Trust, Inc. | In registration | As above | N/A | Monthly | Monthly repurchase offers of 0% to 2% (max 5% per quarter) at Board discretion |
Subscription vs. Redemption Mismatch
It’s important to note that, the CPG Carlyle Commitments Fund and all of the identified credit funds accept subscriptions on a monthly or more frequent basis, but offer share repurchases no more frequently than quarterly. This is a reminder that there are two components to determining an asset’s liquidity: the current price and the time required to convert that asset to cash at that price. Accepting subscriptions requires only that the assets be priced in order to calculate a net asset value (NAV) at which new shares will be purchased. Repurchasing shares may also require that some illiquid underlying assets be converted to cash. This demonstrates another, less obvious risk to illiquid investment products, namely that fair value prices used in calculating the NAV at which new subscriptions are accepted, could be above or below true current market value. If above, new subscribers would be overpaying for shares. If below, existing shareholders’ equity would be diluted.
This phenomenon is partly why the identified Oaktree, Starwood and Blackstone REITs state that new shares, sold at the start of a month, will be sold at a price “generally equal” to the REIT’s prior month end NAV per share. By including that caveat, these REITs have allowed for accepting subscriptions at a NAV per share above or below the NAV calculated as of the end of the prior business day.
Promises, Promises
The easiest promises to keep are the promises that are never made. In that sense, the liquidity offered by PE vintage funds, which make no promises as to when an investors capital will be returned, is the most reliable. It’s important to recognize that, while the other products identified:
- give indications of their intent to provide investors with opportunities to convert their individual holding to cash, and
- some of those indications (i.e. fundamental policies) are stronger than others,
none of these products guarantee the availability of redemptions.
The governing bodies of these co-mingled vehicles have a responsibility to all investors, whether redeeming or remaining, that redemptions reflect orderly market transactions converting illiquid underlying assets to cash. This is why even mutual funds, which “promise” daily liquidity have, on rare occasions, failed to keep that promise. For example, in hindsight, the majority of observers agree that the Third Avenue Focused Credit Fund, a mutual fund, had too high a proportion of illiquid assets in its’ portfolio. However, when faced with significant investor redemptions in December 2015, the SEC agreed with that fund’s trustees' decision to suspend redemptions “to liquidate its assets in an orderly manner and prevent the Fund from being forced to sell assets at unreasonably low prices”.
