The illusion that may be seducing investors

Given that many of these assets have been taken from public markets into private ownership, the answer would appear straightforward – the assets are similar, or the same, so there must be other factors at play to explain any real differences in returns.

An obvious one is that listed companies are valued in real time whenever markets are open. Unlisted companies or assets are valued, not usually by a market, but by desktop valuations conducted periodically that may or may not incorporate some inputs from market developments. That provides an appearance or, some might argue, the illusion of reduced volatility.

Another factor is leverage. Investors in unlisted assets seem to tolerate more leverage than they would be comfortable with in listed markets. Effectively they accept more risk in unlisted markets in exchange for greater (non-risk-adjusted) returns.

Some institutional investors find particular value in particular unlisted assets, notably infrastructure with pricing power (monopolies like tollroads or ports) where they can get direct access to long term, inflation-protected cashflows that match their long-term liabilities. They are less concerned about absolute returns than with their own balance sheets.

None of that resolves the core question of whether a particular asset has a different value depending on whether it is owned publicly or privately.

In Australia, the question of how privately-held assets should be valued was given a particular edge this year as the widely varying valuations of Canva emerged amid the general carnage in the technology sector.

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Various Canva investors wrote down their valuations by between 36 per cent and 60 per cent. Some were quicker to change their valuations than others.

That matters in terms of the performance numbers the funds have reported but also the treatment of individual fund members. A member withdrawing their funds before the valuations changed would benefit, potentially (given how sizeable some funds exposures were to Canva) to the detriment of continuing or new members.

There has been a lot of chatter on Twitter this year about a paper produced by US hedge fund manager, Clifford Asness, a few years ago where he posed the question of whether conventional wisdom had it backwards and, rather than a premium for illiquidity, investors were paying higher prices and accepting lower returns for illiquid assets.

Essentially, he argued that investors in private assets may have realised that illiquid and infrequently priced investments made them better investors because they were unable to panic and redeem their investments during periods of volatility – that they were able to accept a lot more long-term risk if they weren’t confronted with it on a daily basis.

Investors in unlisted assets seem to tolerate more leverage than they would be comfortable with in listed markets. Effectively they accept more risk in unlisted markets in exchange for greater (non-risk-adjusted) returns.

Investors who wouldn’t take a leveraged exposure to listed assets are quite happy to accept that risk in unlisted assets, so there may be something to what Asness argued, although it’s doubtful that super funds or sovereign wealth funds would describe their actions in quite those terms.

The perceived absence of volatility and smoother returns profile because of the valuation lags might, however, encourage them to take a longer-term view of investing that does produce better returns, even discounting for the leverage, than managers trading stocks and other securities in volatile listed markets and under more immediate pressure from their investors.

In the early 1990s, during “the recession we had to have,” Australia experienced a massive commercial property crash and what was a very large unlisted property trust sector imploded.

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The sector had grown dramatically on the illusion that unlisted trusts could produce better and more consistent performance than its listed counterpart even though the underlying portfolios were similar. One explanation proferred at the time was that the unlisted trusts weren’t exposed to the broader performance of equity markets, which might be subject to influences not specific to property.

As it transpired, almost all the unlisted trusts that survived converted to listed entities having suffered liquidity crises and been forced to freeze redemptions after investors tried to withdraw their funds at valuations that predated the crash. When it really mattered, there was a very clear and sizeable illiquidity discount.

With the rapid rise in interest rates and the big falls in the value of listed securities – the US sharemarket is, despite some recent gains, down 17 per cent this year and the tech-laden Nasdaq index 30 per cent – the issues of valuation and liquidity in the listed and unlisted spaces are particularly relevant.

The answer to the question of whether there is a premium or discount for illiquidity may well be clearer once the round of December-end valuations of unlisted assets has been completed, assuming (and it’s probably a bold assumption) those valuations bear any resemblance to the performance of similar assets in public markets.

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