Illiquidity Premium Test
Compare private returns with matched public cash flows before accepting lockup
- Difficulty
- Advanced
- Time to result
- ~ongoing to results
- Steps
- 5
- Confidence
- 96%
Judge a private investment on two levels. First, assess the absolute return the manager underwrites. Second, calculate the relative return against the public-market investment that could have been made instead. To make the comparison meaningful, align when money enters and leaves both alternatives rather than comparing unrelated headline periods. The resulting annualized excess return is the compensation for tying capital up. Olson frames several hundred basis points per year, with roughly 300 basis points as an illustrative ballpark, as a premium that may justify a ten-year private-equity lockup. The framework does not declare a universal hurdle; it makes the trade-off explicit so the investor can decide whether the measured premium is worth the loss of liquidity.
Origin
Extracted from Masters in Business
Core principles
- 01Illiquidity must be compensated
- 02Compare equivalent timing rather than unmatched headline returns
- 03Use both absolute and relative return targets
- 04Treat several hundred basis points of annual outperformance as the decision zone
How to run it
- 1
Set the absolute target
Document the return the private manager expects the portfolio to generate.
Watch out An absolute target alone does not show whether illiquidity is rewarded.
- 2
Choose the public alternative
Select the relevant public-market benchmark the investor could use instead.
Pro tip Match the benchmark to the private strategy's economic exposure.
Watch out An unrelated benchmark can manufacture an apparent premium.
- 3
Align the cash flows
Model money entering and leaving the public alternative at the same times as the private investment.
Watch out Different timing makes return comparisons unreliable.
- 4
Calculate the annual premium
Measure the annualized excess return of the private investment over the matched public alternative.
Pro tip Express the result in basis points per year.
- 5
Decide whether lockup pays
Compare the premium with the duration and burden of illiquidity, using several hundred basis points as the transcript's illustrative decision zone.
Watch out The 300-basis-point figure is a ballpark example, not a guaranteed or universal hurdle.
In the wild
An investor compares a ten-year private-equity fund with the relevant public benchmark using the same contribution and withdrawal dates. If the private fund delivers about 300 basis points more per year, Olson says the investor might conclude that the illiquidity was worth accepting.
→ The investor evaluates lockup through a matched relative-return test instead of relying only on absolute performance.
Common mistakes
Using only absolute returns
A high private return may still be unattractive if a liquid public alternative produced nearly the same result.
Ignoring cash-flow timing
Comparing different entry and exit dates prevents a fair estimate of the illiquidity premium.
Treating a ballpark as a guarantee
The transcript offers roughly 300 basis points as an example, not a fixed rule for every investor or strategy.
Is it for you?
Best for
It is best for comparing a long-duration private fund with a relevant public-market alternative.
Not ideal for
It is not ideal when cash-flow timing or a relevant public benchmark cannot be established.
From the transcript
“But then there's also a relative target, which is how do we think about the premium you're getting for that illiquidity?”
“I want to be paid for that illiquidity.”
“then I think I've been rewarded if I've gotten three hundred basis points a year or something in that ballpark better than the public alternative”
From the episode
Alternate Investing: Masters in Business with Kristin Olson