Illiquidity Premium

The illiquidity premium is the additional return investors demand for holding investments that cannot be easily sold or converted to cash. In private equity and search fund investing, this premium compensates for capital being locked up for 5-10+ years.

How It Works

Liquid Investment (S&P 500):     ~8% annual return
Illiquid Investment (PE fund):   ~12-15% annual return
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Illiquidity Premium:             ~4-7% additional return

Why It Exists

Capital lock-up risk — Investors cannot exit positions when they need cash or when market conditions change.

Valuation uncertainty — Without daily market pricing, the true value of an investment is unknown until exit.

Limited buyer pool — Selling a private equity stake requires finding a willing buyer in a thin secondary market.

Illiquidity Premium in SMB Investing

Search funds and SMB acquisitions typically offer some of the highest illiquidity premiums in private markets:

• Hold periods: 5-7 years typical, sometimes longer
• No secondary market: Limited Partners generally cannot sell their stakes
• Higher target returns: 20-30% IRR targets partly reflect the illiquidity premium
• Smaller check sizes: Lower minimums ($10K-$50K) partially offset the illiquidity burden

Academic Evidence

Research from Stanford GSB and others suggests the illiquidity premium in private equity ranges from 2-4% annually over public market equivalents, though estimates vary based on methodology and vintage year.

Key Considerations for Investors

• Only commit capital you won't need during the fund's life
• Illiquidity premium is not guaranteed — poor fund selection can result in negative returns despite the lock-up
• The premium tends to be higher for smaller, less established managers where the lock-up risk is greater