NEW YORK — Institutional investors should expect a premium for investing in private equity portfolios because the illiquidity could be costing them, according to a new research report from Merrill Lynch & Co., New York.
Private equity investments, which often impose a five- to 10-year lockup period, cannot be rebalanced annually, a fact that may cost investors a premium of about 1.3% per year, according to the report, "Getting Paid For Illiquidity," written by Merrill's pension and endowment strategist, Gordon Latter. That's because an investor cannot take excess returns off the table on an annual basis and thereby would gain a compound annual average rate of return, as opposed to a simple average rate of return.
In a simple example given in the report, investment A and investment B each have $100, but investment A is liquid and investment B is not. In the first year, each investment returns 100%, giving an investor in each a total of $200. An investor in investment A, however, rebalances after the first year by moving the $100 gain to another portfolio, while an investor in investment B cannot. In year two, both investments lose 50%. The investor in investment A still has a $50 gain, while the investor in investment B is left with the original $100. The illiquidity premium in this case would be $50, or 25% of the investment.