CONTRIBUTORS
Tony Davidow, CIMA®
Senior Alternatives Investment Strategist
Franklin Templeton Institute
Priya Thakur, CFA, CAIA
Analyst
Franklin Templeton Institute
Preview
Key points
- Private markets (private equity, private credit and real estate) have historically delivered an “illiquidity premium”
- Institutions and family offices have recognized this illiquidity premium and have historically allocated significant capital to capture it
- Advisors should consider developing an “illiquidity bucket”
- Allocating a portion of a client’s portfolio to illiquid investments helps in maintaining a long-term approach
Legendary investor David Swensen famously stated that the “intelligent acceptance of illiquidity, and a value orientation, constitutes a sensible, conservative approach to portfolio management.”1 What Swensen, and so many other sophisticated investors recognized is the illiquidity premium available by allocating capital to illiquid investments like private equity, private credit and private real estate.
In fact, throughout Swensen’s tenure as the chief investment officer of the Yale endowment, he often allocated between 70%-80% of his portfolio to alternative investments broadly, with illiquidity budgets of up to 50% of the total allocation. The illiquidity bucket is a technique institutions use to identify the amount of capital that they are willing to tie up for an extended period of time (7-10 years). As of the end of fiscal year 2023,2 Yale had a roughly US$41 billion in assets under management, with a 50% illiquidity bucket.
Of course, endowments are very different than individual investors, and Yale has certain built-in advantages, including unique access to private markets, dedicated resources to evaluate opportunities and long-time horizon. If Yale needs capital, it has the ability to reach out to well-heeled alumni and donors for additional capital.
Most high-net-worth (HNW) investors would be uncomfortable locking up so much capital—but the concept of an illiquidity bucket would certainly apply. While high net-worth-investors may not have donors to call upon, they often do share something with Yale—a long time horizon for some of their goals.
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Endnotes:
- Source: David F. Swensen, “Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment.” 2009.
- Source: Yale University. FY23 Financial Report.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Investments in many alternative investment strategies are complex and speculative, entail significant risk and should not be considered a complete investment program. Depending on the product invested in, an investment in alternative strategies may provide for only limited liquidity and is suitable only for persons who can afford to lose the entire amount of their investment. An investment strategy focused primarily on privately held companies presents certain challenges and involves incremental risks as opposed to investments in public companies, such as dealing with the lack of available information about these companies as well as their general lack of liquidity. Diversification does not guarantee a profit or protect against a loss.
Risks of investing in real estate investments include but are not limited to fluctuations in lease occupancy rates and operating expenses, variations in rental schedules, which in turn may be adversely affected by local, state, national or international economic conditions. Such conditions may be impacted by the supply and demand for real estate properties, zoning laws, rent control laws, real property taxes, the availability and costs of financing, and environmental laws. Furthermore, investments in real estate are also impacted by market disruptions caused by regional concerns, political upheaval, sovereign debt crises, and uninsured losses (generally from catastrophic events such as earthquakes, floods and wars). Investments in real estate related securities, such as asset-backed or mortgage-backed securities are subject to prepayment and extension risks.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
Equity securities are subject to price fluctuation and possible loss of principal.
An investment in private securities (such as private equity or private credit) or vehicles which invest in them, should be viewed as illiquid and may require a long-term commitment with no certainty of return. The value of and return on such investments will vary due to, among other things, changes in market rates of interest, general economic conditions, economic conditions in particular industries, the condition of financial markets and the financial condition of the issuers of the investments. There also can be no assurance that companies will list their securities on a securities exchange, as such, the lack of an established, liquid secondary market for some investments may have an adverse effect on the market value of those investments and on an investor’s ability to dispose of them at a favorable time or price. Past performance does not guarantee future results.