MANAGING ILLIQUIDITY RISK ACROSS PUBLIC AND PRIVATE MARKETS
Over the past 50 years, the roles of public and private capital markets have changed slowly but profoundly. In both markets, managing illiquidity risk remains a critical element of portfolio construction.
Public equity markets have gradually evolved from being the primary source of growth financing for corporations to being an income-bearing asset for investors and an acquisition currency for corporations. Looking ahead, we expect over 80% of returns in developed public equity markets over the next 10 years to come from dividends and buybacks, compared with less than half over the last 25 years.
At the same time, private markets, which traditionally provided vital funding for new ventures, have expanded their scale and scope. They now offer capital for many areas that had historically been financed by public equity markets.
Investors in private assets take on Illiquidity risk and assume it is compensated by higher returns. That is essentially correct, but full compensation is only captured by above-median managers. Some public assets may also have embedded illiquidity risk, but it is more cyclical and not always fully compensated.
Optimizing returns from the private part of the portfolio means staying the course and harvesting the illiquidity premium over the cycle. This suggests that any cash calls or redemptions may be disproportionately financed by the sale of public assets. Understanding that there is a cyclical element to the illiquidity risk premium in public assets is an important subtlety in optimally navigating a sophisticated multi-asset portfolio through the cycle.
While larger and more sophisticated investors have a greater propensity to take on private market illiquidity risk, there is no economy of scale in dealing with public market illiquidity. Investment horizon may be a significant mitigating factor, however. Investors with a long investment horizon are commensurately more able to assume illiquidity risk in private assets and ride out episodes of uncompensated illiquidity risk in public markets.
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EVALUATING AND MANAGING ILLIQUIDITY RISKS TO HELP BUILD STRONGER PORTFOLIOS
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2019 Long-Term Capital Market Assumptions