At most billion-dollar endowments for American colleges and universities up until the early 2000s or so, the only question was: “What percentage of the portfolio should be invested in stocks, and what percent in bonds?” The scope of being “original” was limited to investing in small-cap stocks, real estate investment trusts, or purchasing debt issued by a governmental entity outside of the United States.
David Swensen, who has earned 12% returns since managing a portion of Yale’s endowment in the early 1980s, gained attention for investing in alternative investments that led to outperformance of average American endowments by almost six percent annually.
In particular, Swensen would invest in highly illiquid investments, capturing a premium that is often believed to exist due to the non-saleability of a particular asset. If you start an LLC whose sole asset is a rental property that earns $1,000 per month, the ownership of that property should be cheaper than if it were part of a residential real estate investment trust that traded hundreds of thousands of ownership shares each day.
Being able to sell something on a whim has economic value, and therefore, a higher valuation should extend to an asset that you can sell compared to the valuation of that same asset that is held in a manner that is more difficult to transfer ownership.
Swensen’s theory was that you are able to get your hands on more earnings and more earnings growth if you are willing to search for high-quality assets that exist in the context of closely held corporations and partnerships.
What Swensen realized, however, is that investing in illiquid assets is only a source of alpha outperformance to the extent that it represents an attractive asset with low competition for ownership. As soon as that variable changes, and the gap between the valuations of illiquid assets and liquid assets tightens, the potential for seemingly free excess return also dissipates.
From 1992 through 2017, the discount for investing in an illiquid asset compared to its closest liquid peer was almost 15%. During 2009, these gaps hit almost 30% (meaning that, in addition to the distressed valuations available during the financial crisis, you were able to capture an extra 30% discount if the business you purchased wasn’t publicly or easily traded). Right now, the illiquidity discount is only at 9%. The extra compensation that you receive for purchasing an illiquid asset is currently at a generational low, and therefore, the rewards for stylistically mirroring Swensen’s investment strategy at Yale should offer minimal, if any, reward.