Is the Illiquidity Premium Still Real?

Generally speaking, 'illiquid' assets typically offer a higher compenation/return due to the fact that investors cannot readily sell the asset. We spoke with First Eagle Investments to discuss the current state of 'illiquidity premium' within private markets, and how insurers should be thinking about the space.

Katie Cowan | Managing Director, Global Head of Insurance Client Solutions | First Eagle Investments
katie.cowan@firsteagle.com | Learn More >>

SAA: For insurance companies still becoming familiar with private markets, how would you explain ‘illiquidity premium?’ What exactly are we being compensated for in private markets today?

First Eagle: The “illiquidity premium” can generally be defined as the potential additional return investors seek for committing capital to an asset that cannot be readily sold at a transparent market price, commonplace in alternatives or private investments. However, in today’s private markets, investors are rarely being compensated for illiquidity alone. The return generated may also reflect the work required to source less-intermediated opportunities, conduct specialized underwriting, negotiate bespoke terms, monitor collateral, and provide capital in more opaque markets.

For insurers, one of the most important questions is whether the investment’s liquidity profile is appropriate for the company’s liabilities and whether the incremental return adequately compensates for the full range of risks, costs, potential accounting nuances and operational requirements. Not every additional unit of spread in a private asset is necessarily attributed strictly to illiquidity. It may also reflect credit, leverage, structural, or execution risk. The objective is to find yield attached to risks that can be understood, controlled, and appropriately compensated for within a given portfolio.

SAA: Has the growth of private capital structurally compressed the illiquidity premium?

First Eagle: Not uniformly. That being said, in certain parts of the market where capital is abundant and lenders are competing for similar transactions, such as direct lending, the premium is not the same as it was a decade or so ago. As markets become more accessible, liquid, and efficient, it can result in tighter spreads and, in some cases, weaker structural protections due to the aforementioned competition.

As a result, the distinction between market segments has become increasingly important. Insurers must continue to look to the traditional areas of the diligence process when sourcing private alternative investments: manager selection, underwriting discipline and diversification.

SAA: Is today’s premium more accurately described as a “complexity premium” than an illiquidity premium?

First Eagle: In our view, complexity and illiquidity are somewhat related components rather than interchangeable terms. “Illiquidity” describes what an investor may give up, specifically the ability to readily sell an asset, while “complexity” describes the specialized work required to originate, underwrite, structure, and control the investment.

The “complexity premium” may arise from solving nonstandard origination, legal, collateral, or structuring challenges that fewer investors have the experience or resources to address. Structure can also shape outcomes through covenants, collateral priority, cash controls, reporting requirements, and intercreditor protections.

Strategic Asset Alliance, First Eagle Investments. The information contained herein has been obtained from sources believed to be reliable, but the accuracy of information cannot be guaranteed.

Disclosures:

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