In praise of illiquidity

In a 2006 letter to shareholders of Berkshire Hathaway, Warren Buffett lampooned hedge and private equity fund managers as malevolent “helpers” who cause investors to minimise returns.

Buffett was trying to make a point about the frictional costs of frequently getting in and out of stocks. The wisest investors, he wrote, hold on to investments indefinitely and gradually accumulate wealth. By contrast, investors who constantly rearrange their portfolios are more likely to earn lower returns and gradually transfer their wealth into the hands of advice-givers and fee-earning transactors.

It’s hard to find fault in Buffett’s core argument. Not only does portfolio churn take precious basis points away from returns in the form of fees, but research suggests that investors who frequently act on new ideas are more likely than not to be acting impulsively, buying high and selling low.

David Snow

And while private equity funds are guilty-as-charged in the fee department, Buffett overlooks an inherent structure that forces – or at least, highly encourages – investors to remain committed to investment ideas for very long periods of time. Indeed, long-term investment is a strategy much celebrated by Buffett, who has never sold a share in his own company and who rarely sells anything in the Berkshire Hathaway portfolio.

One of the most noticeable features of private equity throughout the economic crisis was its stubborn refusal to become liquid. Major institutions found themselves dumping public equities to generate cash while their alternative assets ballooned in relative value and refused to budge. Hedge funds had to all but vacate their stock holdings to meet redemption demands, but they were unable to get relief from their oversized, illiquid “side pockets”.

The economic crisis gave illiquidity a bad name, and indeed, one still hears grumbles about private equity as being unacceptable in certain portfolios because of its inability to be dumped at will, secondary market notwithstanding.
But this is an asset class that looks terrible in its youth but becomes more handsome as it ages. The howls of disdain for illiquidity will gradually give way to renewed enthusiasm for the way that private equity locks partners into multi-year commitments, ultimately rewarding them as far forward as two business cycles into the future.

Alongside the many proponents of illiquidity who kept the faith throughout the downturn, powerful new voices in the asset class are singing the praises of long-term investment horizons, and these voices are likely to inspire a new generation asset-class participants.

One such voice comes from Seoul, Korea and belongs to Scott Kalb, the chief investment officer of the Korea Investment Corporation, the country’s $38 billion sovereign wealth fund. Speaking at a recent IFC/EMPEA conference on private equity in the emerging markets, Kalb devoted most of his time to praising private equity’s ability to lock up capital for a very long time. He seemed wary of the gyrations of the stock markets and their propensity to being driven by mere sentiment. His organisation has no need for liquidity in the short term and therefore, “Why should we be concerned with what happens in the next quarter?” he asked.

Nothing made him happier than seeing a private equity firm scoop up business assets because doing so “takes them off the table” and presumably denies public markets from subjecting the share values to such loony volatility.
Kalb’s views were welcome and should be further proselytised, because an asset class that has always been associated with long-term returns is about to get even more long term.

James Bachman, who as director of research for private equity software provider Burgiss Group has been tracking LP cash flows for years, says his company recently determined the average number of years it takes for investors in buyout funds to make it out of the famous J-curve: nine. In other words, an investor who puts a dollar into a buyout fund will have to wait an average of nine excruciating years to get that dollar back. This wait will become protracted by one or two extra years, Bachman estimates, because of the unusually slow pace of deal activity in more recent buyout vintages.

The good news is that investors typically emerge from the J-curve with their dollar back and an impressive collection of residual value in the portfolio still to be realised. But unless advocates for this asset class are somewhat aggressive in reminding newcomers that long waits are the norm in private equity, its illiquidity risks becoming a pejorative instead of a badge of honour.