Private equity transactions can provide investors with tremendous upside and a tangible impact on the communities served—especially important when it comes to emerging markets. But investing in private equity can also reduce liquidity, as these funds may be “locked up” for a period of years, even a decade or longer.
How can investors strike a good balance between rates of return and liquidity? Below, Zachary Fond of Alta Semper Capital explains more about the impact of liquidity costs when analyzing private equity investments.
Private Equity’s Liquidity Challenge
Publicly-traded securities have a low barrier to entry. This barrier is lowered even further with trading programs and apps that allow users to purchase shares for as little as $1. If the price of an investment starts dropping, or if the investment no longer fits within one’s asset allocation, the owner can quickly sell and realize their gains (or losses), then reallocate these funds to another investment.
Private equity investments, on the other hand, often require the initial investment funds to be “locked up” for the life of the fund—anywhere from five years to 10 years or longer. “Many investors find the inability to withdraw their funds to be one of the biggest risks of private equity,” Fond explains. And this lack of liquidity can impact one’s ability to expand their horizons by investing in other private equity or publicly-traded investments.
Striking the Liquidity Balance
One answer to the liquidity problem involves the secondary market for private equity stakes. Investors who want to realize the value of their investment immediately—albeit with a slight convenience fee—can sell their stake in the secondary market and exit their financial commitment to the fund.
In these transactions, the buyer will pay the seller for the portion of the commitment that has already been drawn down; the buyer will then assume the obligation to pay all future management fees associated with the investment and participate in any required future investments. The seller then gives up any right to future distributions.
A recent study indicated that the average discount over the full sample was 13.8 percent of net asset value. “However,” Fond explained, “this discount can vary widely based on the fund age and overall market conditions, especially during a recession.” This study included assets sold during the 2008 financial crisis, so excluding this data, most transactions for funds between four and nine years old have only a nine percent net asset value discount.
While it may seem logical that higher transaction costs are associated with smaller and/or poorly performing funds, this isn’t always the case. Higher transaction costs (or steeper net asset value discounts) are associated with larger funds, as well as well-performing ones. And depending on how quickly the seller needs to exit the transaction, a significant discount may be necessary to quickly offload the fund.
There are other discounting factors that aren’t fund-dependent. For example, during recessions or depressions when there is less capital available to purchase illiquid securities, transaction costs can be far higher. And buyers who are concerned about the fund’s future performance when compared to prior performance may be less willing to pay list price, especially if the fund is an obscure or difficult-to-research one.
Fond is optimistic about the burgeoning secondary market for private equity transactions. “This market is poised to become more liquid over time,” he explains, “which will help diminish any impact of the illiquidity of private equity investments and make them more attractive to a broader array of investors.” Fond believes that lowering the barriers to entry for private equity investors can be a boon for the overall equity market, particularly in emerging markets, and should help draw in more institutional investors responsible for making broad portfolio decisions.
About the Author:
Zachary Fond joined Alta Semper Capital, LLP in 2016 and brought to his career over 10 years of experience in the private equity investing and financial advisory sectors. Before joining the private equity management firm, he was the senior associate at Emerging Capital Partners. There, he covered consumer, retail, and logistics investments in Kenya. He began his career in the investment banking divisions of UBS and Goldman Sachs, in Johannesburg and New York. He received his BA in economics from Cornell University and an MBA from the University of Pennsylvania’s Wharton School. We’re happy to have Fond on our team.
At Alta Semper, we take a sector-based approach to private equity. We don’t believe Africa is an asset class, but a series of sovereign countries with their history and competitive advantages. Our investments are focused on consumer and healthcare sectors in stable, well-diversified countries, and provide a solid return to investors while allowing them to do good. If you’re interested in more information on these investments, visit our website today.
