See the great piece here by Jonathan Ford, on why pension fund investors continue to pump huge allocations at private equity, given that the returns, net of fees, are no better than the return on the stock market, and given the pricing opacity and illiquidity of private equity.
An intriguing answer, suggested to him by the hedge fund manager, Cliff Asness, is that “pricing opacity and illiquidity are not actually bugs in the private equity model, but features that investors willingly pay for”.
It is not beyond pension funds to invest in transparently-priced liquid equity, but such transparency is an unwelcome freedom.
A bad downturn, or a spell of fierce volatility, might persuade them [the pension fund], or their trustees, to crack and sell out at a disadvantageous moment.
“Liquid, accurately priced investments let you know how volatile they are and smack your face with it,” he [Asness] says. Opaquely-priced and illiquid private equity, by contrast, obliterates the temptation. Just as Odysseus stuffed beeswax in his crew’s ears and had them lash him to a mast to resist the call of the sirens, pension funds use the manacles of a private equity contract to resist liquidity’s lure.
Eumaeus loves the reference to his master Odysseus! And where have we heard this before in a different context?
62. Solvency II, however, provides that insurers matching certain long-term liabilities with assets that they can buy-to-hold may seek regulatory approval to value those liabilities using a “matching adjustment”. This allows an insurer to value its insurance liabilities using a discount rate that is higher than the risk-free rate. The rationale is that the return from certain long-term assets includes an element that compensates the investor for the market illiquidity of the asset. An insurer intending to hold the asset to maturity (to match a long-term liability) will not, however, be exposed to illiquidity risk. In short, an element of the return on the asset is to benefit the insurer-investor for a risk that it is not exposed to. (In the Matter of the Equitable Life Assurance Society, 4 Dec 2019)
Of course the Sirens were a Bad Thing, and Odysseus seems to have understood what he was doing when he had himself trussed up, as Jonathan says.
But how many of the pension funds accepting private equity’s “illiquidity discount” are doing so knowingly? Illiquidity is not costless. That is why it is supposed to be compensated. Those costs have been suppressed in recent years, when bear markets have tended to be short and sharp. But consider the impact of a prolonged 1970s style downturn. Then investors might rue the shackles they paid to don.
My emphasis.