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Illiquidity Premium
Definition
The illiquidity premium is the additional return that compensates investors for the inability to access their capital on demand. Assets such as private equity, venture capital, real estate, and infrastructure typically offer higher expected returns than publicly traded equivalents because investors require compensation for: (1) the inability to sell during periods of market stress; (2) the uncertainty of exit timing; and (3) the costs and complexity of managing illiquid investments. Empirical estimates of the illiquidity premium vary by asset class and market conditions but generally range from 2-4% annually for private equity over public equity equivalents.
In the Context of Endowment Management
The illiquidity premium is the theoretical basis for the endowment model's heavy alternatives allocation. Endowments and foundations are structurally well-positioned to capture this premium because their perpetual time horizon and limited near-term liquidity needs allow them to commit capital for extended periods. However, smaller foundations (below ~$100M AUM) should carefully assess whether their liquidity needs, manager access constraints, and operational capacity justify the alternatives exposure required to capture a meaningful illiquidity premium.