The Liquidity Problem in LP Investing
by Ari Shpanya
For a long time, limited partners (LPs) and venture capitalists (VCs) across the board have faced a structural problem — the illiquid nature of their investments.
Various groups have gone as far to saying that the traditional venture model is broken. Although there are others who disagree, what we are left with is an industry where there is a clear imbalance between the levels of cash inflow and outflow.
According to Tomer Dean, a TechCrunch contributor:
“Ninety-five percent of VCs aren’t actually returning enough money to justify the risk, fees and illiquidity their investors (LPs) are taking on by investing in their funds.”
Already, there are fewer investor groups (and startups — another subject entirely) willing to tie themselves down in the traditional venture capital investing process, since its nature involves the long lock-up of capital in tandem with unpredictable performance.
In the past, LPs have consisted primarily of large institutions and wealthy families. Today however, all sorts of entities and individuals can become accredited investors — despite lacking the deep pockets that the larger institutions are blessed with.
These individuals might not enjoy the massive wealth that pillar institutions do, but they are looking to invest what they have in exclusive transactions, venture capital, and private equity (PE). The fact that they have the opportunity to become involved in these once-exclusive classes of investment is a huge deal — or at least, it should be.
Locked Value
Unfortunately, the reality is the lack of control that individuals have over their investments is weighing down what would otherwise be a massive upward trend. Ultimately this is inhibiting the natural evolution of the market environment and keeping out millions of potential smaller, everyday investors.
For the LP investors that do get through the door, they typically enjoy few rights to either influence or direct the funds’ activities. From the time between initial investment to exit, they have extremely limited control.
“From the time between initial investment to exit, LP investors have extremely limited control.”
PE and VC funds typically have a minimum initial contractual life for investors of ten years, most often taking the form of an LP. During the first five to six years, the fund manager can draw down from the capital committed by investors — the timing and frequency of which lies completely out of the hands of investors.
After this long period, the manager can generally no longer draw down leftover capital, save for eventualities such as fees and expenses. It’s only when investments are realized (or, when underlying companies are sold, liquidated, or go public) that capital and profits are distributed back to investors. There is simply no way of liquidating LP interests before that date without resorting to transaction on the secondary market.
“There is simply no way of liquidating LP interests before that date without resorting to transaction on the secondary market.”
The Secondary Market Misconception
Traditionally, secondary market transactions of LP positions typically occur when the fund is between the ages of four and nine years old. The concept of a ‘secondary market’ for an early exit from a fund seems to imply liquidity, but in many ways it is nothing more than an illusion of liquidity.
Potentially, all parties could benefit while sellers still outperform buyers in this market if they were capable of routinely selling their positions. This would require sellers to move their positions at higher prices on the secondary market than they would otherwise receive from holding those positions through maturity — a mechanism that would also allow buyers to still realize strong returns.
This is pure optimism or, however, and is not at all illustrative of the typical case because most secondary markets lack volume. In actuality, buyers on the secondary market usually outperform sellers. Resulting in buyers who take advantage of low volume’s to realize steep discount rates in the secondary market enjoying significantly higher returns than the sellers.
As mentioned above, Investors who sell on a low-volume secondary market are forced to sell at a discount. The frequency and reduced price of these discounted sales are common and extreme enough that they have even earned the nickname “fire sale”. While prospective buyers may flock to this chance, sellers end up with the shortest end of the stick and lose out on their funds’ underlying values.
The Uber Example
A famous example of this phenomenon occurred in 2014 when an early onset Uber employee tried to sell his stock. The company refused to sign off on the transaction, instead offering to buy back the shares that should have been worth $200 at a fire sale discount price of a mere $135 per share. The employee was forced to either sell at the severely discounted price or else continue holding.
At such a steep discount, most people would probably have chosen to hold and wait as this particular person was forced to. So what is the point of having a low-volume secondary market at all when it clearly doesn’t exist for the benefit of the sellers? Or, perhaps more to the point, is this even true liquidity if it comes at such great financial loss? Some might say this is simply the inherent cost of transacting in the secondary market, and that is the risk of LP equity investment in general.
No matter how you approach it, the fact that investors accept such risks as inevitable in their own industry is both concerning and telling. Staking millions of dollars on high-risk business ventures is an action that takes some amount of inherent optimism, so if investors and experts lose their confidence, there must truly be a bug somewhere in the system.
That Illiquidity Bug
Illiquidity is one of the central risks when considering private equity as an investor’s chosen asset class. The risk of loss associated with selling LP interests on the secondary market is unavoidably high. Therefore it cannot go ignored when considering an initial investment. Of course, investors could always opt to avoid the risk outright and simply hold for the entire ten-year period. But nobody wants that as their sole option.
How liquid an asset is, is a key factor in any investment. In a perfect world, an investor would have complete ease of access over all their wealth. They would have the control. Do what is best for themselves financially. Investors will always want to be able to sell their assets if the need or the desire arises, so naturally, the looming potential of becoming trapped in an investment for a decade or more (with no option for exit beyond a substantial financial loss) is keeping potential investors on the outside of a lucrative industry.
Private equity market participants tend to believe that at the very least liquidity has improved over time. They claim the biggest factor in this has undoubtedly been the growth of the secondary market, partially fueled by rising valuations. But the valuation process is widely viewed as flawed, and although liquidity has improved, it has not improved nearly enough.
When Will There Be a Change?
It seems we are long overdue for an overhaul to this broken system. The vast majority of those in the industry believe more advances in liquidity and secondary-market volume are needed, and history shows that when advancements are needed, someone somewhere will undoubtedly step up to drive them forward.
In fact, multiple companies are already in the process of building the technology needed to drive the next step in the liquidity evolution. Slice, available soon in Q3 2018 and powered by blockchain technology, is set out to completely revolutionize the process of accessing, investing and liquidating one of the most lucrative investment classes, commercial real-estate.
About: Slice is set out to solve some of the most pressing problems international investors face when turning to invest in US commercial real estate: limited access, fees imposed by 3rd parties, lack of transparency, and illiquidity. To learn more about how Slice is going to tackle these problems, download our white paper (link below) or visit us at slice.market.
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