In 2015, Stephen Kaplan (Chicago Booth) showed a chart at the CAIA Annual Conference. US buyout IRRs from 1986-2014 matched S&P 500 returns over the same periods, implying the illiquidity premium may have been captured by managers rather than LPs. You will need several tools to answer that question for yourself: PME (in both KS and LN forms), the interim IRR, the multiples suite (TVPI, DPI, RVPI), and a working understanding of why aggregating IRRs across funds breaks.
Evidence on illiquidity premium from listed assets. Before comparing private to public, liquid markets already price illiquidity. You can measure the premium without ever buying a PE fund.
Factor-pricing explanation. Illiquid securities tend to have bid-ask spreads that widen and prices that drop during market turmoil, especially in bear markets. That means they deliver relatively low returns in bad times and relatively high returns in good times. This is exactly the condition under which investors should demand a risk premium (higher expected returns) for holding less liquid securities.
Common mistakes
- Treating the simple IRR average as the portfolio IRR. For the Example 2 table, the equal-weighted average is 15.2%. Trap: this appears as the "portfolio IRR" answer choice. The equal-weighted and commitment-weighted averages are legitimate measures of selection and sizing skill, but neither equals the pooled portfolio IRR.
- Confusing KS-PME with LN PME. KS-PME is a ratio that is always defined. LN PME is IRR-based and can have multiple solutions (up to the number of sign changes) or no solution at all when the hypothetical market investment loses money.
- Treating TVPI and DPI as interchangeable. A 2.50x TVPI with 0.13x DPI (Fund C) is 95% unrealized. A 1.98x TVPI with 1.77x DPI (Fund A) is 89% realized. Trap: comparing two funds by TVPI alone and calling them equal. The first carries full markdown risk; the second is essentially closed.
Bottom line
- Illiquid assets pay low returns in bad times and high returns in good times, the factor-pricing condition for a risk premium; the listed-equity premium now matters only for the smallest stocks.
- Net of fees, listed REITs have outperformed private real estate over long samples; Case found every academic study reviewed shows public beat private real estate.
- The 2008-09 NPI/NAREIT divergence has two explanations: efficient REIT prices with appraisal-smoothed NPI, or REIT volatility as public-equity contagion.
- PME compares private cash flows to a same-dates public-index account; KS-PME above 1 means private won, while LN PME IRRs may be multiple or absent (use the profitability index).
Exam shortcut
On a PME question, beating the public market means KS-PME above 1, but remember the Kauffman 1.34 breakeven when illiquidity compensation is at issue. If the stem gives cash flows but skips the terminal NAV, the omitted-NAV figure is usually the distractor, since both PME and IIRR always include the remaining NAV.
The full lesson (about 4,490 words, 30 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- replication overview
- case for replication
- replication benefits
- factor replication
- algorithmic replication
- hf risk returns evidence
- hf access approaches
- fohf characteristics
- fohf construction
- fohf value add
- investable hf indices
- private vs listed
- unlisted re funds
- pe re performance drivers
- listed re funds
- investing commodities
- etns private commodities
- leveraged option commodities
- managing commodity exposure
- accessing digital assets
- illiquidity premium listed
- private vs listed re perf
- pme challenges
- multiple eval tools
- irr aggregation
- private fund considerations
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