Legendary investor David Swensen famously stated the “intelligent acceptance of illiquidity and a value orientation constitutes a sensible, conservative approach to portfolio management.” What Swensen, and so many other sophisticated investors recognized, is the illiquidity premium available by allocating capital to illiquid investments such as private equity, private credit and private real estate.

In fact, throughout Swensen’s tenure as CIO of the Yale endowment, he often allocated between 70 percent and 80 percent of his portfolio to alternative investments broadly, with illiquidity budgets of up to 50 percent of their total allocation. The illiquidity bucket is a technique used by institutions to identify the amount of capital they are willing to tie-up for an extended period of time (seven to 10 years).

Of course, endowments are very different than individual investors, and Yale has certain built-in advantages, including unique access to private markets, dedicated resources to evaluate opportunities and a long time horizon. If Yale needs capital, it has the ability to reach out to well-heeled alumni and donors for additional capital.

Most high-net-worth investors would be uncomfortable locking up so much capital, but the concept of an illiquidity bucket would certainly apply. While high-net-worth investors may not have donors to call upon, they often do share something with Yale, a long time horizon for some of their goals.

WHAT THE DATA SHOW

Academic research has shown the historic persistence of an illiquidity premium — the excess return received for tying up capital for an extended period of time. This makes intuitive sense because you are providing the private fund manager ample time to source opportunities and unlock value. The fund manager isn’t beholden to investors and shareholders, like their public market equivalents, who are viewing results over shorter intervals.

While the magnitude of the illiquidity premium will vary over time, depending upon the market environment and the fund, the data show that private equity, private credit and private real estate have historically delivered a substantial illiquidity premium relative to their public market equivalents.

Until recently, high-net-worth investors had limited access to these elusive investments due to investor eligibility and high minimums. However, thanks to product innovation, and a willingness of institutional-quality managers to bring products to the wealth management marketplace, high-net-worth investors now have a growing array of options to select from.

HOW MUCH TO ALLOCATE

The amount of capital to allocate to illiquid investments varies by investor and the underlying liquidity profile. Many investors believe they should be 100 percent liquid, but there is an opportunity cost to being liquid, especially in today’s market environment. Traditional liquid market investments will likely deliver returns below their historical averages, and advisers may need to consider private markets to help investors achieve their goals.

One way of determining the appropriate percentage to allocate to private markets is to develop an illiquidity bucket. Similar to the Yale example covered earlier, the illiquidity bucket should represent the amount of capital that an investor is willing and able to tie up for seven to 10 years. It can be determined via the discovery process, and advisers should designate these investments as long-term in nature.

As advisers determine the family’s needs and requirements, they should inquire about short- and long-term liquidity needs. Does the client have significant capital expenditures in the next couple of years (college tuition, purchasing a second home, a boat, etc.)? How much of the client’s portfolio needs to be short-term in nature to meet financial needs? What portion is the client comfortable putting aside for the next seven to 10 years?

For many high-net-worth investors, a 10 percent to 20 percent illiquidity bucket may be appropriate given wealth, income and cash-flow needs. Once the adviser has determined the illiquidity bucket, he or she can define which asset classes are appropriate to achieve client goals.

ALLOCATING TO PRIVATE MARKETS

Once the illiquidity bucket has been established for a particular client, the adviser can determine the appropriate allocation to private markets. There are several factors to consider before allocating.

• What are the family’s goals and objectives?
• What is the optimal combination of asset classes (traditional and alternatives)?
• What are the types of investments that provide the highest likelihood of achieving goals?
• What is the most appropriate type of fund, given the investor’s wealth and liquidity profile?
• What is the appropriate amount of capital to allocate per strategy?

As with any investment, advisers must understand and evaluate the many dimensions of a fund before recommending structure and strategy. Because of the specialized nature of conducting due diligence on private markets, advisers may rely on due diligence conducted by their firm or a third-party provider.

THE LONG GAME

The bottom line: There is a potential illiquidity premium for allocating capital to private markets. The illiquidity premium is the reward for giving the fund manager ample time to execute the strategy and unlock value.

Advisers should help investors determine their illiquidity bucket. The illiquidity bucket should be determined based on each investor’s ability to allocate capital for an extended seven- to 10-year period of time. An illiquidity bucket can help instill a long-term, disciplined approach that can remove the impulses to respond to emotional stimuli.

Tony Davidow is senior alternatives investment strategist at the Franklin Templeton Institute.