Investors have historically paid too much to access illiquid assets, a new study by global consultancy firm Willis Towers Watson (WTW) has found.
In a just-published research paper, WTW says – based on its bespoke measure – the illiquidity risk premium (IRP) has been below fair value for longer periods than above it.
According to the paper titled ‘Understanding and measuring the illiquidity risk premium’, the finding implies either investors expect too much from the IRP or WTW “misestimated that average”.
“Or, it may reveal that the maxim ‘what gets measured gets managed’ holds true,” the WTW report says, “we believe our approach to assessing the IRP is fairly unique, and therefore it seems likely that the IRP was too low simply because the average investor did not appreciate it was too low.”
The WTW model defines IRP as the ‘residual’ of any given asset class expected return after deducting an estimated risk-free rate, credit premium and losses, and ‘alpha’.
“Whilst [the IRP measure] has its limitations, we believe this approach is extremely powerful as it is a) intuitive, b) fairly simple in principle and c) the only one we have!” the paper says.
The WTW ‘IRP Index’, constructed out of data for a range of traditionally illiquid assets, shows the illiquidity premium has varied considerably over time, spiking most recently from a low of about -10 basis points (bps) late in 2006 to a high above 2.5 per cent mid 2008.
“In recent years, the additional returns on offer from illiquid assets have been relatively attractive and should have encouraged the long-term investor to exploit them,” the report says.
However, the IRP Index bounced around since the 2009 peak before sliding consistently from 2012.
For example, the WTW report shows the IRP for European direct loans declined from 3.73 per cent in March 2013 to 1.96 per cent at the end of 2014.
“As to whether illiquid assets are in aggregate providing returns that are too low, that really comes down to the investor’s specific utility function…,” the study says.
“However, on average we would regard the general level of available illiquidity risk premia of the assets we measure to be moving into the lower end of the range of fair value.”
And broader market trends driven by divergent global monetary policies and a structural decline in capital markets liquidity could introduce more risk for investors in illiquid assets.
“In aggregate, the pressures on the global IRP are likely to continue to be lower for some time, reflecting the amalgamation of these forces and conditional on no downside event materialising,” the WTW report says. “Investors are being encouraged to search for yield, and in a low-return world illiquidity risk is potentially an appealing means of generating additional yields. However, we believe there to be a higher chance than normal of a downside event occurring, pushing all risk premia – including IRPs –higher.”
For instance, another recently-released WTW research paper titled ‘Capital markets liquidity’ warns a crisis could be looming in the credit markets.
In a statement, Chris Redmond, WTW global head of credit research, said there was a concern that “the supply of liquidity is no longer capable of satiating demand”.
“This will become obvious and painful during periods of market stress where investors seek to re-position or realise cash from commingled funds offering overly generous redemption terms,” Redmond said.
Despite the downside risks, the WTW IRP research says for those who have the time-frame and nerve illiquid assets should deliver the goods.
“… if a negative event does occur and illiquidity risk premia do increase, these clients should stand ready to capture these attractive returns,” the study says. “Often this requires investment at a worrying time, but having a solid process to estimate the IRP… eases this decision.”
The report says investors should assess illiquid assets based on three factors: their risk tolerance (or ‘utility function’); illiquidity level of the underlying assets, and; the volatility and uncertainty of underlying cash flows.
While the ‘utility function’ is specific to each investor, the WTW study estimates the average ‘required IRP’ should range from about 50-100 bps for more liquid/less volatile assets to 150-250 bps at the top of the illiquidity/volatility range.
As an aside, the WTW report ranks private equity outside the measurable IRP spectrum.
“… whilst we suspect private equity does provide an IRP to some degree, it is onerous to disentangle it from the control, skill and other risk premia that drive the additional expected returns of private equity over its listed sibling,” the study says.