Reconsidering the Illiquidity Premium
The performance gap between public and private markets is often attributed to the illiquidity premium. Investors accept reduced flexibility in exchange for a higher expected return. Indeed, private assets often require multiyear lockups and are more complex to exit. But this explanation is incomplete.
Most investors allocate only a portion of their portfolios to private markets, thereby mitigating the true impact of illiquidity. Additionally, innovations such as secondary markets are enhancing liquidity options. If the illiquidity premium were the sole driver of returns, greater demand and improving exit mechanisms should logically reduce it. Yet outperformance has persisted, suggesting another factor is at work.
The Complexity Premium: Creating Value Through Skill
A deeper driver of private market returns lies in what Schroders has termed the “complexity premium.”[2] This refers to the return earned not for taking on more risk, but for successfully navigating complexity through skill and operational enhancement.
This concept mirrors the value creation process in private equity: investing in an underperforming or sub-optimized asset and improving its fundamentals through active management. Consider the example of a dated property in a prime location. A passive owner may rely on market appreciation. A skilled investor, however, may renovate, rezone, or restructure its use, generating higher returns through active transformation.
In private markets, this principle applies not only to real estate but across asset classes. The performance differential stems from specialized teams adding value over the holding period through strategic, operational, and financial interventions.
In contrast, public market investors, especially those without a controlling stake, often have limited ability to influence management decisions. Voting structures and corporate governance limitations dilute investor power, rendering them largely passive participants. This lack of influence limits value creation opportunities and underscores the strategic advantage of private market investing.
Four Stages of Value Creation
Private market investing is not a single act but a sequence of high-skill stages, each of which contributes to the complexity premium:
1- Sourcing: Access to quality deals requires strong relationships and exposure to opportunities not widely available to the public.
2- Assessment: Not all deals are created equal. Discerning quality requires rigorous due diligence, sector experience, and the ability to identify hidden risks or upside.
3- Execution and Management: Value is created through active oversight, including strategic shifts, capital restructuring, or operational improvements.
4- Exit Strategy: Realizing value is as important as creating it. This requires positioning the asset attractively for the right buyer at the right time.
Because these skills are not broadly distributed, it is natural that investors with the ability to execute them successfully should earn a premium.
The Role of Transparency and Alignment
Contrary to assumptions, private markets are not opaque by default. While public companies are required to disclose earnings and filings, private investors often gain deeper access to financials, management, and strategy during due diligence and ongoing monitoring. This closeness allows for more informed decision-making, especially when investing alongside aligned partners.
However, transparency alone does not ensure returns. The true differentiator is how information is applied through judgment, insight, and execution.
Conclusion
The strong performance of private markets isn’t just about locking up capital for a few years. It reflects the ability of skilled teams to unlock value through a multi-stage process of identifying, enhancing, and exiting investments.
At The Family Office, we bring over two decades of experience navigating the complexity of private markets. With over $2.1 billion in assets under management and a global network of partners, our team specializes in co-investments across private equity and private credit. We offer our clients access to select opportunities where complexity is not a barrier, but a gateway to value.
