The illiquidity premium is part of the investment strategy of a savvy investor. Private equity funds, in particular , involve a risk of capital loss, a long holding period, and limited opportunities for early exit.
Use in an Investment Strategy
The illiquidity premium allows for a comparison of the expected return on an unlisted asset with that of a liquid asset having similar economic characteristics. This analysis must take into account the investment horizon, business risk, leverage, fees, diversification, and exit conditions.
It should not be interpreted as an automatically earned performance bonus.Illiquidity is a definite constraint, while the return on that investment remains uncertain.
Investing involves the risk of capital loss.
How does the illiquidity premium work in private equity?
Capital Lock-Up
In a closed-end private equity fund, investors typically commit their capital for several years. The capital is called down gradually, invested in unlisted companies, and then returned as those companies are sold.
For reference, the model agreement proposed by the Institutional Limited Partners Association provides for a ten-year fund term, which may be extended twice for one year each time. The actual terms vary depending on each fund’s legal documentation.
During this period, investors generally do not have a permanent right to redeem their shares. A sale on the secondary market may sometimes be considered, though there is no guarantee regarding the timing or price of such a sale.
The expected payoff from the constraint
In financial theory, an illiquid asset must offer a higher expected return than a comparable liquid asset. This difference constitutes the illiquidity premium.
The simplified formula is as follows:
Illiquidity premium = expected return on the illiquid asset – expected return on a comparable liquid asset
This comparison requires assets with a similar level of economic risk. A difference in returns may also stem from the size of the companies, their industry, debt levels, entry price, the quality of the in Fund manager , or fees.
An estimate that varies depending on the method used
A study by Francesco Franzoni, Eric Nowak, and Ludovic Phalippou, published in *The Journal of Finance* in 2012, examines 4,403 private equity investments that were exited between 1975 and 2006.
The authors estimate a liquidity risk premium of close to 3 percent per year for this historical sample. However, this result does not constitute a universal standard. The premium varies depending on the time period, strategy, holding period, financing terms, and the depth of the secondary market.
Illiquidity Premium and Value Creation
The illiquidity premium should not be confused with the creation of operational value. A fund can support a company in its growth, digital transformation, international expansion, governance, or acquisitions.
These transformations depend on the Fund manager ’s and management teams’ ability to execute effectively. They do not automatically result from tying up capital.
A fund's overall performance may also be influenced by:
- the purchase price;
- the company's growth;
- improved margins;
- changes in the valuation multiple;
- debt;
- the conditions for release;
- the fund's expenses.
Illiquidity is therefore only one component of the expected return.
How do you calculate the illiquidity premium?
Suppose a liquid asset has an expected annual return of 8%.
A comparable illiquid asset has an expected annual return of 11%.
The apparent premium is therefore three points:
11% - 8% = 3%
With an initial investment of 100,000 euros held for five years, with no cash flows in between:
100,000 × (1 + 8%)⁵ = 146,933 euros
100,000 × (1 + 11%)⁵ = 168,506 euros
The first scenario yields a theoretical profit of 46,933 euros. The second yields a theoretical profit of 68,506 euros. The difference is therefore 21,573 euros.
This example is based on constant assumptions. It does not take into account fees, taxes, inflation, or the schedule of capital calls and distributions.
Nor can the yield spread be entirely attributed to illiquidity without further analysis. Part of it may result from higher risk, leverage, or differences among the assets being compared.
Is the illiquidity premium guaranteed?
No. An asset can be both illiquid and underperforming. The financed company may encounter difficulties, its value may decline, and it may be sold under unfavorable terms.
As explained earlier, illiquidity is certainly a constraint, but the return on that illiquidity remains uncertain.
Historical returns that exceed those of listed markets do not prove the existence of a pure illiquidity premium either. In particular, we must distinguish between:
- economic risk;
- exposure to small businesses;
- debt;
- expenses;
- selection bias;
- the quality of operational support;
- market conditions at the time of acquisitions and divestitures.
The illiquidity premium should therefore never be presented as an additional guaranteed return.
What is the role of the secondary market?
The secondary market allows an investor to sell a stake in a fund before its maturity date. This option can increase the flexibility of an investment portfolio, but it does not guarantee an immediate sale or a price equal to the most recent published value.
The sale price depends, in particular, on:
- the quality of the portfolio;
- the age of the fund;
- expected distributions;
- insight into outings;
- the number of buyers;
- financing terms;
- the seller's need for liquidity.
Evergreen and semi-liquid funds may offer redemption windows. These are generally subject to caps, time limits, or suspension mechanisms. Organized liquidity differs from the daily liquidity of a listed asset.
How has the concept evolved?
1986: Liquidity Is Incorporated into Return Models
In 1986, Yakov Amihud and Haim Mendelson published a study on the relationship between return and the bid-ask spread. Their research shows that investors may demand a higher expected return for holding assets with higher transaction costs.
This research focuses on listed markets, but it helps to formalize the idea that liquidity has economic value.
The 1990s and 2000s: The Growth of Private Assets
The growth of private equity, venture capital, unlisted real estate, and infrastructure is driving increased interest in measuring illiquidity.
Institutional investors therefore seek to compare private assets with listed markets. This remains a complex task due to the lack of daily prices, irregular cash flows, and the difficulty of creating a perfectly comparable liquid asset.
2012: An Estimate for the Private Equity Sector
Franzoni, Nowak, and Phalippou have published their study on the performance and liquidity risk of private equity. They estimate a premium of nearly 3% per year based on their historical sample.
The authors also show that the estimated alpha declines sharply when liquidity risk is taken into account. Part of the observed return may therefore reflect a risk premium rather than independent outperformance.
2025: More Regulated Valuations
The IPEV 2025 recommendations update the practices for valuing private investments at fair value. They aim to improve the consistency and transparency of the valuations used by managers and investors.
The illiquidity premium remains, however, an estimate. No standard sets a single rate applicable to all funds, all strategies, and all time periods.
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