No Liquidity without Price

The title of last week’s PEI‘s Friday Letter, “No Dice without Liquidity”, identifies the critical element determining the reported decision of KKR to stop promoting two retail products.

“When it comes to accessing retail money, lack of liquidity is private equity’s Achilles’ heel.”

In spite of KKR’s reported claims of successes in raising money from individual investors and the reiterated declarations of intent of many alternative investment management powerhouses to access this vast money pool, the liquidity puzzle has yet to be solved.

The lack of liquidity ties KKR’s latest retail exercise with the many attempts to attract retail money, be it in form of permanent capital vehicles (listed investment vehicles) or open-end mutual funds:

  • Apollo, Blackstone, KKR have had to transform their investment vehicles in (or list as) asset management holding companies to escape the “valuation trap” (and the associated discount on NAV – assuming that NAV is fairly calculated, but I’ll write about this in a specific future post) of listed private equity indices, that has been entangling their listed funds;
  • Listed private equity indices have not recovered pre-crisis levels and seem to track the US financials sectoral index (source: Lpe vs S&P vs SPR US Fin
  • Open-end multi-alternatives fund pioneer Mark Yusko had to abandon the lead of the USD 3.5 Billion Endowment Fund he co-founded as roughly a third of the assets were withdrawn from the fund in 2012 causing the gates to be temporarily closed.

The PEI’s letter suggests that “perhaps product innovation and clever structuring really will pave a way for the industry into retail“. Or refers to the listed private equity indices and vehicles as more liquid (market conditions allowing) alternatives.

I think that the private capital industry has to shift gears and integrate valuation transparency lessons that other asset classes have learned if it wants to properly access and serve the retail and the DC pension money pools.

Liquidity is a function of the availability of interested traders which in turn relies on the possibility they have of exploiting arbitrage transactions.

Theory and experience demonstrate that liquidity depends on the existence of two conditions (plus one):

  1. An equitable and transparent pricing mechanism;
  2. Efficient risk transfer instruments.

The listed markets only provide for the second condition, at least in part, as shares are easily transferable. Still, permanent capital vehicles remain a sub-optimal investment structure because of the systematic NAV discount they carry (as said, I intend to work on this topic in a future post).

As for the first condition, markets seem to “take a shortcut” tying listed private equity vehicles to indices representing pro-cyclical high beta financials, often trading below par.  But, as most LBO funds are  investing in non financial assets – admittedly with a geared structured that could be mirrored by a beta adjusted S&P – this does not look quite right.

I have shown in previous posts that pricing private equity funds can be a rational and transparent relative valuation exercise.

Defining private markets valuations in time weighted terms leads to the third condition – the truly critical one – indeed implicit in the notion of pricing:

Realistic and investable indices are the true indispensable element for accessing retail markets. They provide relative value reference, valuation transparency and mental anchoring and are the basis for low-cost, simple and easy to transfer products and structures.

The reward for this indexing perspective looks attractive….


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