The Illiquidity Premium
The illiquidity premium is the price discount that investors require to hold an asset that cannot be traded for intervals of uncertain length, which appears as a higher expected return on the asset.
Reviewed by Peleg Chevion, Managing Partner
Mechanism
Ang, Papanikolaou and Westerfield define illiquidity as the restriction that an asset cannot be traded for intervals of uncertain duration (NBER Working Paper 19436, September 2013; published in Management Science, 2014). The same working paper defines the illiquidity premium as the price discount of an illiquid security, distinct from the illiquidity risk premium, which prices protection against a liquidity crisis (footnote 4). A lower price for the same expected payoff is, arithmetically, a higher expected return.
The authors find that uncertainty about the length of the illiquid interval, as opposed to a fixed non-trading interval, is a primary determinant of the cost.
A private fund has no continuous price, so the premium is measured indirectly, by replaying the fund’s cash flows in a public index. The public market equivalent (PME) of Kaplan and Schoar (2005) is the measure that compares a fund with an equivalently timed investment in a public index. Harris, Jenkinson and Kaplan describe it, in their February 2012 NBER Working Paper 17874, as all distributions and residual value carried to a common date at the public market total return, divided by all contributions carried the same way. With Ct as contributions, Dt as distributions and residual value, and It as the index level at date t:
PME = Σ Dt × (IT / It) ÷ Σ Ct × (IT / It)
The same working paper states that a PME above one means the fund outperformed the public market net of fees, and that a PME of 1.20 means investors ended with 20 percent more than a public-market investment would have produced. Cambridge Associates uses a modified version (mPME) that avoids the negative net asset value inherent in some PME methods.
Worked Example
Consider a hypothetical $100 million fund that draws $100 million at the start and returns $180 million at the end of year five, while the public index rises from 100 to 150. The PME is (180 ÷ 1.50) ÷ 100 = 1.20. The fund’s annualized return is 12.5 percent against 8.4 percent for the index, a difference of about 4.0 percentage points. The 1.20 does not isolate compensation for illiquidity from manager skill or market risk.
The Cambridge Associates US Private Equity Index, built from 1,801 funds formed between 1983 and 2026, reports pooled returns net of fees, expenses and carried interest, against a Russell 3000 mPME, as of March 31, 2026:
| Horizon | Index return (%) | Russell 3000 mPME (%) | Value-add (basis points) |
|---|---|---|---|
| 5-year | 9.15 | 11.43 | -227 |
| 10-year | 15.08 | 13.95 | 113 |
| 20-year | 12.88 | 10.60 | 228 |
| 25-year | 12.76 | 10.03 | 273 |
The same source shows negative value-add at the 1-year (-1,196) and 3-year (-1,061) horizons. At the 20-year and 25-year horizons, the Cambridge Associates index exceeded the Russell 3000 mPME by 228 and 273 basis points a year, or 2.28 and 2.73 percentage points, as of March 31, 2026. These are historical pooled index results, not a forecast.
For the denominator effect, take a hypothetical $1 billion portfolio with $850 million public and $150 million private assets, a 15.0 percent private weight. If the public assets fall 20 percent to $680 million and the private holdings stay at $150 million, the weight becomes $150 million ÷ $830 million, or 18.1 percent, with no new commitment.
What It Means for a Limited Partner
A limited partner reads the premium against three features of the asset class rather than as a promised excess return. The first is timing: uncertain interval length lowers the optimal allocation to both the illiquid and the liquid risky asset (Ang, Papanikolaou and Westerfield). The second is the denominator effect, which a consultant explained to the Rhode Island State Investment Commission on March 27, 2024 when the plan’s private equity weight exceeded its target. The third is commitment pacing, described in the same minutes as a model whose goal is to bring the plan gradually to its target weight.
The historical evidence depends on horizon, period and data source. Kaplan and Schoar (2005) found average net fund returns approximately equal to the S&P 500, with substantial heterogeneity across funds. Harris, Jenkinson and Kaplan (2014) found that average U.S. buyout fund performance exceeded the S&P 500 by 20 to 27 percent over a fund’s life, or more than 3 percent annually, as the October 2014 Journal of Finance abstract states, while venture capital funds beat public equities in the 1990s but trailed them in the 2000s.
In Life Sciences and Healthcare
In therapeutics, liquidity events follow regulatory and clinical milestones that no holder controls. The U.S. Food and Drug Administration describes Phase 1 as lasting several months, Phase 2 as several months to two years and Phase 3 as one to four years, with approximately 70 percent, 33 percent and 25 to 30 percent of drugs moving to the next phase. Once a New Drug Application is complete, the agency has 6 to 10 months to decide whether to approve the drug. The end of the holding interval therefore depends on trial readouts and review decisions, and uncertainty about the length of that interval is what Ang, Papanikolaou and Westerfield identify as a primary determinant of the cost of illiquidity.
Governing Authority and Sources
- Ang, Papanikolaou and Westerfield, “Portfolio Choice with Illiquid Assets,” Management Science 60(11): 2737–2761 (2014), abstract; NBER Working Paper 19436 (2013), nber.org/papers/w19436.
- Kaplan and Schoar, “Private Equity Performance: Returns, Persistence, and Capital Flows,” Journal of Finance 60(4): 1791–1823 (2005), abstract.
- Harris, Jenkinson and Kaplan, “Private Equity Performance: What Do We Know?” Journal of Finance 69(5): 1851–1882 (2014), abstract; NBER Working Paper 17874 (2012), nber.org/papers/w17874.
- Cambridge Associates, US Private Equity Index and Selected Benchmark Statistics, March 31, 2026.
- Rhode Island State Investment Commission, meeting book of April 24, 2024, including minutes of March 27, 2024.
- U.S. Food and Drug Administration, The Drug Development Process: Step 3 and Step 4.
Frequently Asked Questions
What is the denominator effect?
The denominator effect is the rise in the private share of a portfolio when public holdings fall and private holdings are carried at unchanged values. In the hypothetical $1 billion portfolio above, a 20 percent decline in the public portion lifts the private weight from 15.0 percent to 18.1 percent. Rhode Island’s State Investment Commission minutes of March 27, 2024 record a consultant explaining the effect.
What is the illiquidity premium?
The illiquidity premium is the price discount of an illiquid security, as Ang, Papanikolaou and Westerfield define it. In private equity it is estimated indirectly, by comparing fund cash flows with a public index, as in the Kaplan and Schoar public market equivalent. That estimate also reflects manager skill and market risk, so it is not a pure measure of compensation for illiquidity.
What is commitment pacing?
Commitment pacing is the use of a model to set the level of new private fund commitments so that private holdings reach a target weight gradually. The Rhode Island State Investment Commission minutes of March 27, 2024 record its consultant describing that goal and noting that such models evolve as assumptions change, and separately addressing the effect of higher interest rates on capital calls and distributions.
Related Reference
This entry belongs to the Growth Equity thesis. Related entries: The J-Curve, Private Equity Secondaries and Family Offices in Private Equity.