Valuing a Lost Opportunity: An Alternative Perspective on the Illiquidity Discount

Abstract

The illiquidity discount is the valuation discount investors apply to investments as compensation for their lack of immediate marketability. The authors analyze the concept of the illiquidity discount in the specific context of private investments whereby investors are precluded from accessing their capital, potentially for periods as long as several years. Although many explanations have been put forth for why such discounts should exist, as well as for their magnitude, the authors posit an alternative explanation based on the concept of opportunity cost: By holding an illiquid asset, an investor forgoes the potential excess returns that could have been generated by trading the liquid markets. The authors derive a basic mathematical model to show that the illiquidity discount should be directly related to the magnitude of trading opportunities on the horizon. Investors who believe their future investment opportunities to be favorable should command commensurately large illiquidity discounts for tying up capital. This implies that more skilled investors should require larger illiquidity discounts than their less skilled counterparts. Finally, the authors conjecture that the equilibrium illiquidity discount priced into private markets at any given time is primarily a function of investors’ perceived skill rather than actual skill. This highlights an important behavioral component to the pricing of private investments.

TOPICS: Long-term/retirement investing, portfolio construction, real assets/alternative investments/private equity, theory, in portfolio management

Key Findings

• ▪ Investors command illiquidity discounts for locking up capital in proportion to their perception of excess return opportunities on the horizon.

• ▪ More highly skilled investors will command higher illiquidity discounts because their opportunity cost for tying up capital is greater than for average investors.

• ▪ The equilibrium illiquidity discount for private investments will be a function of investors’ perceived skill rather than actual skill.