Reports of Buyout’s Liquidity Risk Are Greatly Exaggerated
Key findings
- Portfolios with realistic, diversified buyout investments have required only modest liquidity buffers to meet capital calls over the past two decades.
- When liquidity buffers have come under stress, it has generally been due to declines in public equity markets rather than correlated capital calls or evaporating distributions from buyout funds.
- The weak evidence of liquidity risk suggests buyout funds may have generated more alpha than is commonly understood.
Private-market excess returns are often attributed to a liquidity premium — excess compensation for bearing liquidity risk.[1] We define "liquidity risk" as the risk that investors may be unable to meet future cash-flow demands because of illiquid components of their portfolio. Despite the conventional wisdom, we find little evidence of this risk over the past two decades except in undiversified portfolios with extremely aggressive private-asset targets.[2]
Consider a limited partner (LP) with a liquid portfolio of broad public equities that adopts a simple commitment policy in 2000, targeting 15% of portfolio net asset value (NAV) in buyout.[3] If the LP committed to just one buyout fund per vintage — a very undiversified private sub-portfolio — the 95th percentile liquidity drawdown peaks at just over 3% of the liquid holdings, posing minimal liquidity risk.[4] Increasing diversification by instead committing to four buyout funds per vintage further reduces the risk that capital calls will strain the LP's public-equity liquidity buffer.
Portfolios with modest buyout-allocation targets faced trivial liquidity risk
Simulated buyout sub-portfolios selling shares of a broad basket of public equities to fund capital calls. We proxy the public equity portfolio using the MSCI ACWI Index. The portfolio starts in 2000 fully invested in public equities, then ramps up to a target of 15% of NAV in buyout. Cash flows as a fraction of liquid holdings are calculated monthly. For readability, we plot the highest monthly liquidity buffer drawdown per quarter.
Regardless of buyout diversification, the LP faces the greatest expected liquidity drawdown during the ramp-up phase. During this period, the LP must make large commitments to funds that are intensively calling capital but distributing very little. As the portfolio approaches its steady-state target — 15% of NAV in buyout — it reduces its commitments to new vintages, lessening capital calls, and begins receiving distributions from its initial investments.
Across the aggregate buyout market, capital calls and distributions are strongly positively correlated; that is, private-asset funds tend to make large capital calls at the same time as other private-asset funds are returning large amounts of capital. As a result, portfolios that have reached steady state have tended to require minimal liquidity buffers. However, a steeper ramp-up policy front-loads capital calls more heavily, creating greater liquidity demand at a portfolio's outset.
A walk on the wild side
To find the limits of private-asset allocation, we simulate a wildly imprudent investment policy that combines an extremely aggressive 60% buyout target and no diversification — enough to make most investors queasy. Increasing the buyout target to 60% of NAV exposes an undiversified LP to extreme risk, potentially requiring them to liquidate half of their public-equity portfolio in a single month. While the LP targeting 15% of NAV in buyout benefited from diversification, an LP with this more aggressive target will have greater need to diversify. Simply diversifying the buyout sub-portfolio to four commitments per vintage more than halves the liquidity buffer at risk.
Aggressive buyout-allocation targets demand diversification
Simulated buyout sub-portfolios selling shares of a broad basket of public equities to fund capital calls. We proxy the public equity portfolio using the MSCI ACWI Index. The portfolio starts in 2000 fully invested in public equities, then ramps up to a target of 60% of NAV in buyout. Cash flows as a fraction of liquid holdings are calculated monthly. For readability, we plot the highest monthly liquidity buffer drawdown per quarter.
Beyond the ramp-up window, the diversified LP faces manageable liquidity demands even with an aggressive buyout target. It is important to note here that our framework is likely to overstate liquidity risk for most LPs — we invest our liquidity buffer into relatively volatile public equities with no cash or fixed-income allocation; this means our liquidity buffer is liable to drop during times of market turmoil, even apart from net capital calls from the buyout sub-portfolio.
In practice, for a diversified portfolio, sharp spikes in liquidity drawdowns are generally driven by short-term changes in public markets rather than a surge of capital calls. The spike in capital calls as a share of the liquidity buffer in late 2008 — most visible in the four-commitment portfolios — corresponds not to liquidity demands from private markets, but a 20% month-on-month drop in the MSCI ACWI Index amid fallout from the collapse of Lehman Brothers. A liquidity buffer with cash and fixed-income allocations would have faced less volatility in that case.
Small liquidity buffers for realistic portfolios
Despite the much-discussed liquidity premium in private equity, we do not see realistic scenarios from recent years in which buyout investments would have created major liquidity problems for their investors. While an obviously unwise investment policy — targeting a large and under-diversified fraction of the portfolio in buyout — can leave an LP in a perilous position, more reasonably constructed portfolios have faced surprisingly little liquidity risk.
1 Arthur Korteweg. “Risk and Return in Private Equity.” Handbook of the Economics of Corporate Finance, Vol 1: Private Equity and Entrepreneurial Finance.2 Our findings relating to liquidity over the past 20 years have been dominated by generally positive markets for buyout funds. A prolonged period of severe downturn in distributions from funds could constitute a liquidity risk that we do not observe in our sample period.3 While simple, the policy is dynamic, committing more capital when underallocated and less when overallocated. Our analysis focuses on buyout because it is the largest private-asset class and serves as a good illustrative example for a basic portfolio.4 By “liquidity drawdown” we refer to the net capital calls (capital calls less distributions) faced by the LP as a share of its public-equity liquidity buffer.
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