So how does a private and illiquid REIT compete? Offer a higher yield. How does 6% sound? This is the illiquidity premium.
If an advisor allocates client funds solely into liquid assets, they are leaving money on the table, fact! I am by no means advocating for tying up 80% of assets into less liquid products but a percentage of assets in securities with an illiquidity premium will raise the average return of the portfolio. If an advisor is doing their job correctly and planning time horizons; emergency funds; life events etc. then they know what percentage of capital can be tied up for a period of time and can capitalize on the higher returns available.
“Expected Returns” by Antti Illmanen, 2011 as cited in “Private Capital, Private Opportunities” by Blackstone. © Michael Kitces
Retirement Accounts
I had this conversation with my friend Kyle Kadish, from AGES at a conference recently. His explanation was so eloquent that I asked to him summarize it for the purposes of this article.
“Investors and savers contribute to IRAs and 401k’s to grow their net worth tax-efficiently; the tax-free or tax-deferred growth comes with the stipulation of reaching a certain age. A qualified account’s inherent illiquidity structure neatly matches some illiquid investments’ illiquidity nature. For investors with a longer time horizon, as they continue to accumulate wealth, or those seeking higher income due to the illiquidity premia with certain investments, a qualified account could be the right place to source funds for the illiquid investment.
• This should not change any suitability, net worth or income requirements of an investment.
• Investors and advisors should always keep RMD age limits in mind when allocating to illiquid investments through a qualified account.”
—Kyle Kadish, AGES Financial Services Ltd.
Reinvestment Risk
“Reinvestment risk refers to the possibility that an investor will be unable to reinvest cash flows received from an investment, such as coupon payments or interest, at a rate comparable to their current rate of return. This new rate is called the reinvestment rate.”
Careful and successful financial planning requires predictability of cash flows, particularly if these cash flows are matched to liabilities. If I invest into a 5% 1-year bond-type structure and the interest environment changes, perhaps I should have invested into a 5-year product, which may well have offered me a premium at 6%. We can all play the gambling game of what happens if interest rates increase but I will take predictability over speculation all day. Illiquid investments eliminate or at least mitigate this risk.
Redemptions
One additional point that deserves consideration is that of redemptions. This was addressed by Freddie Lait, managing partner of U.K.-based Latitude Investment Management LP.
“Illiquidity is a risk which has been mispriced over the past 10 years as quantitative easing programs have flooded financial systems with cash, and regulators have allowed funds to run liquidity mismatches in their portfolio.”
The problem arises with this mismatch when investors get skittish and a fund cannot meet their redemption demands. This is certainly a consideration for interval funds or other semi-liquid options but most of the sponsors in this space are illiquid until exit. It certainly makes sense to push this point in any due diligence conversations where limited liquidity is offered, the ability of the sponsor to meet a max redemption demand.
“There’s price for liquidity, and that typically equates to lower returns. For many alternative sponsors providing liquidity essentially means money is sitting on the sideline not earning a premium or in other words there’s a “dead money,” component. I believe most investors given the option of having all of their money working for them or only a portion would choose the former if they are fully educated on the investment. While it’s certainly nice to have liquidity available, illiquidity helps to remove emotions from the equation.” —Todd Woodhead, EVP Capital Markets, Walton Global.