Risk premia refers to the amount of excess return an asset must produce over that offered by a less risky asset (say a t-bill), to entice an investor to hold it. As many investors shy away from risk in the wake of the financial crisis, opportunities arise for those who can stomach it, to capture some the risk premia available in the market. Equity risk premium is an obvious one, but another promising one is the illiquidity premium- there are great returns to be had for the investor who can handle long-term lock ups.
Q. So this is a way that many allocators are thinking about their portfolio construction these days, right?
A. Yes. Ever since the crash, there has been an ongoing re-evaluation of allocation strategies, and this is one of the big topics. Instead of thinking specifically about asset classes per se, look at where you’ll get paid the most for investing. A big source of income– maybe the biggest for most people– is the equity risk premium, but there are other kinds of risk premia out there for capture, too.
Q. Well, like what?
A. The big one is illiquidity. The fear level right now is so high that everyone is demanding liquidity in their investments. That makes it a buyers market for people with the cash and stomach to go into a locked up, multiyear investment. There are “illiquidity premiums” to be captured.
Q. But there are different kinds of illiquid investments, of course. Where are the illiquidity premiums highest?
A. Yes. Hedge funds might require a one year lockup, especially strategies like activist or distressed, which need time to work. Then, you go further out into venture and PE deals, including real estate. One example: there are a few solid RE deals in the market now where investors can essentially step into the shoes of the GP, and earn part of his “promote” or “carry”… but, of course, you’ve got to live with the illiquidity.
Q. And there are other kinds of “risk premia” to capture, too?
A. There are. “Size” is one… like anything else in life, you can essentially earn a volume discount in some transactions by committing larger chunks. “Enterprise” is another… for example, there are some great young hedge fund managers out there now with new funds. Sure, there’s more risk in investing with them as opposed to Ochs-Ziff, but you can often bargain to get either reduced fees, or a piece of the GP, for taking that risk. That’s another one of the “risk premia” that’s available for capture.