Illiquidity Premiums in Real Estate and Private Equity | Erik Averill, Brandon Averill | AWM Insights #70

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Episode Summary

With the all-time market highs that we’re seeing despite fears of inflation, we’re also continuing to see the popularity of real estate investing and venture capital private equity. But whether you just dip your toe in or dive in headfirst to these kinds of investments – are you getting the returns you deserve?

When investing in these spaces, they require more patient capital that can’t be pulled out very quickly. This is known as illiquid assets and can sometimes get a negative rap. However, we think illiquidity can be a great thing as long as you’re being compensated for it.

This concept – known as an illiquidity premium – is the focus of Erik and Brandon’s discussion today where they discuss what it is, why it can be a good thing for investors, and the opportunity costs to consider of having your assets tied up in illiquidity.

 
 
 

Episode Highlights

  • (00:24) The news you should know: MLB All-Star Game, All-time market highs

  • (2:14) What is the illiquidity premium and what does it apply to?

  • (3:12) Illiquidity premiums in real estate and venture capital

  • (4:46) How should investors look at illiquidity?

  • (5:48) What are the opportunity costs of illiquidity?

  • (8:29) What are interval funds?

  • (10:19) Elevator analogy

  • (11:16) What does risk mean to you?

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AWM Capital: IG | LinkedIn | Facebook | AWMCap.com

Brandon Averill: LinkedIn
Erik Averill: LinkedIn | Instagram

+ Read the Transcript

Erik Averill (00:17):

Hey, everyone. Welcome back to AWM Insights. It is your power two this week. It's Erik and Brandon. Our CFA is out on vacation. And so we'll do our best to cut through the noise this week of what Wall Street is selling you to bring you the knowledge, skills, and access that you need to invest like a pro. And so today, we're going to tackle the topic of the illiquidity premium, and what I mean by that is we talk so much on this podcast about accessing higher returns in the private markets and we just want to dive into one of the big components of why an investor should demand such a higher return than the public markets. But before we jump into that, we are taping this on Friday, July 9th, before heading into the All-Star Weekend. So many of our listeners know we have a huge passion for baseball, and we have seven players that are in the All-Star Game this weekend, and so Brandon and I will be in Denver celebrating with them.

Erik Averill (01:20):

And then one other piece of news is just interesting times. It's Friday, all time highs in the markets continue to go even with fears of inflation, and so I think just once again understanding of how difficult it is to time markets, that no matter what some fears are going on in the day-to-day news, we're still seeing the markets at all time highs. And so Brandon, with that, let's jump into this conversation. Where I would love to start it, we know so many people love the asset class of real estate right now given what's going on in the markets or this boom around venture capital private equity, and we talk a lot about demanding higher returns. Can you explain what the illiquidity premium is and just jump off from there?

Brandon Averill (02:14):

Yeah. Erik, so the illiquidity premium, I'll put my Justin hat on, try to go CIO here. I'll try not to get too technical, but at the end of the day, the illiquidity premium really is you being compensated for tying up your money in the most simple way. And so that illiquidity premium applies to asset classes, like you mentioned, Erik, of real estate or private equity or venture capital. And really the purpose here is that these are asset classes that typically require more patient capital, that require access to capital, that can't be pulled very quickly. And because of that, you're able to build companies or work on a real estate project and allow for a longer lead time. Often times, this illiquidity gets a negative rap, but really when we look at it, it's really a great thing so long as you're being compensated for it.

Brandon Averill (03:12):

And so I think a real good understanding of it, understanding that you should be compensated for it is where you start. So whether you're an intro investor really looking at the real estate side and saying, "Hey, I want to go buy this property. I want to do X, Y, and Z. I want to take it out of the market," you should accept a higher rate of return or expect a higher rate of return for taking on that additional risk. And basically what the risk is, is that something happens in your life and you need that money, you can't turn around and sell a building, maybe in 30 days, but that's not going to be a very advantageous sale. But it's much more difficult to actually liquefy, take your money out of that project. Same goes with the private equity and venture capital side. The reason why you have higher expected returns partly in that asset classes because it takes a long time to build companies.

Brandon Averill (04:15):

The life cycle of these companies, you start at the seed stage and you go to Series A, and we have all these levels, well, that's because it takes a while to build companies. And our exit most likely is either an acquisition from another company or going public. And that just takes time. So as an investor, you're willing to forego your money over that period of time and for doing so you expect a higher return.

Erik Averill (04:46):

And something I think that gets missed a lot of times when it comes to how we deploy capital, to your point. Is this illiquidity gets demonized as if it's this horrible thing. But when we look at very wealthy families, multi-generational families or institutional investors, endowments, when you have a long, long time horizon, a lot of times it is these private markets that are going to produce the best returns. And it's this redefinition of what risk is really married to when you need that capital. And so, to your point, hearing that if you deploy money into venture capital, it may be tied up for 10 to 12 years, but with some of the families that we work with that have this multi-generational timeframe, they actually get to outperform other people and rewarded for that tying their money up.

Erik Averill (05:48):

And then one other thing I'd love for you to hit on that doesn't get talked about enough is the opportunity costs. It's not just, can I have my money in case I need to spend it? It's that when I choose to invest my money in a specific investment, it means I'm also saying no to so many other different investments. And this is why we talk at nauseum about making sure that you are demanding the returns that you deserve. That based off of what the evidence says, where the sources of returns come from, you should really be looking at not only is this a good investment in isolation, but comparatively to what else is available to me, I'm not going to be able to deploy my capital in that way. And so I'd just love to hear your thoughts of how you think through opportunity cost and where to place your money.

Brandon Averill (06:43):

Yeah, I think that's a good point, Erik. And I think the other part of this is, like you said, if you have patient capital, if you can match your longterm needs for capital, and you're willing to go into these asset classes, you're typically going to at least have the expectation of higher return. It's in big part, David Swensen, the famous manager from Yale's Endowment, he understood this, and he brought this into the asset allocation of Yale's Endowment. And I mean, they were rewarded handsomely for participating in private equity and venture capital specifically. And so when you're looking at time horizons as such, if you're looking at multi-generational wealth, I think there's an extreme strong argument because you have the ability to tie up your capital for a good bit of time.

Brandon Averill (07:32):

And so I think this is definitely something that people, if you have a good understanding, you've put it in the right place, it works really well. The other part is, so many people miss the mark here. I think they think of real estate or even other asset classes, they think there's no volatility. They look in their publicly traded accounts, they see it go up and down, it feels like a roller coaster. With these other assets, you don't see the value most often in these illiquid assets and so you feel like they're safer. They're no more safer. It's just you're not having somebody walk up to your real estate project on a daily basis and present you with an offer. If they did, you'd probably see this same type of up and down. So I think there's additional benefits, certainly behaviorally, to the illiquidity side of the portfolio.

Brandon Averill (08:29):

And then I think the other good thing for people to keep in mind is when you start to see traditionally illiquid asset classes, real estate, private equity, venture capital, and people are offering more liquid options, there are things in our world called interval funds, if there's these big institutions that are coming and saying, "Hey, we can give you quarterly redemptions in this and that," you have to turn on your brain and go, "Hey, a minute. This is a longterm asset class. How are you giving me that liquidity? How are you giving me access to my capital on those intervals?" And the answer is, usually there's a trade off. You're either getting less quality of an asset or there's some mechanism that is certainly affecting your expected return at the end of the day.

Erik Averill (09:21):

You bring up so many helpful and great points there of understanding what we're investing in and what true risk is. We define for our multi-generational families, risk is really the permanent loss of capital, not short term up and down of just the temporary valuation of the asset. And so one of the things that's a head scratcher a lot of times is I made the comment with a client the other day that the public stock market historically is actually a very safe place to deploy your capital. Because what we know is that, over the longterm, that if I buy pieces and ownership of companies that I can diversify across the globe, across 10,000 companies, that over time I'm going to get the public market return, I'm going to get the market premium return.

Erik Averill (10:19):

And we dove into that conversation because a lot of times I think we're fearful of just the market as if it's this black box. I mean, you're buying pieces of companies over a very long time. It's actually one of the safest ways to grow your wealth, the public stock market. On the flip side, we had talked about investment real estate, and what happens a lot of times is a client might feel more comfortable saying, "Hey, I just want to buy a single property that I want to rent out, or even a single piece of land that I believe is going to grow in value over time." We love this analogy. If you're on two elevators, if you've got a shot that you've got to go up 100 floors and there's two elevators that you've got to go on, one of them's held by only one cable and the other one's got five cables attached to the elevator, my question is, which one would you feel most comfortable in if one of those cables broke?

Erik Averill (11:16):

Clearly, we would all say, "Hey, I want to be in the elevator that has five." It's got the fail safe that if one of them goes out, we're all right. Yet when it comes to investing sometimes just because there's this physical building that I can see with my eyes, I deem that as safer than actually deploying my money into multiple businesses in a very public way. And so I think one of the takeaways we hope that you have today is really redefining, what does risk mean to you? Is it just short-term fluctuation or is it the permanent loss of capital?

Brandon Averill (12:03):

Yeah, I think those are fantastic points, Erik. I think really orienting yourself on that expected return, what should you expect if you're tying up your capital? Any time that you have an asset class that is a longer term type investment and you have liquidity to it, ask what you may be giving up? And with that kind of mindset, I think you'll end up in a good spot to make sure that it all comes back to the financial structure, which we've hit on so many times, but when you have your priorities laid out, you can start to match up the assets that you should be invested in. And if you happen to have your essential and your important priorities and quite frankly your discretionary priorities really accomplished, then yes, absolutely, finding some illiquidity, some of this illiquidity premium, some of these assets that are going to take time to grow. You should be allocated there. But don't put the cart before the horse. Make sure you understand it. Make sure you understand what you should expect in a return.

Erik Averill (13:11):

Yeah, and I think that's a great point to end it in. Just understand what you're investing in. Understand what your expectations are. We say it time and time again that you've worked so hard for this money that we just want you to learn how to invest like a pro so you can capture the returns that you deserve, and also not put your priorities at risk, because at the end of the day, money is just a tool. It's a tool to be used to accomplish your priorities and have the impact on the people and the causes that are most important to you. And so head over to AWMinsights.com. You can access all of this in the show notes. And until next time, own your wealth, make an impact, and always be a pro.