The importance of liquidity risk in private markets

Investment risk is conventionally divided into three main types:

• Market risk, which the investor bears by participating in a particular market and can’t be diversified away.

• Idiosyncratic risk, which is specific to the asset in question and can be diversified away.

• Liquidity risk, which is the risk that the investor is unable able to turn the asset into cash without suffering a material discount.

Up to the point that interest rates started normalising in 2022, no one made much of a distinction between the liquidity risk borne by investors in private equity on the one hand and private credit on the other. Both, indeed, were held to benefit from an “illiquidity premium”, where the returns to investors were higher than those available in the public markets because of the investments’ illiquid nature.

Roll the clock forward a few years and the difference in liquidity risk between private equity and private credit is becoming rather sharper. Whereas private credit enjoys regular cash interest payments and repayments of principal with a fixed maturity date, private equity investors that want to see their fund interests turned into cash are having to resort in increasing numbers to a secondary market that is not shy about demanding large discounts to NAV.

To put this difference into perspective, in 2024 the volume of secondary sales of private equity funds (as a proportion of global PE assets under management) was 4.4 times higher than the equivalent number in private credit.

The lesson for investors is that net returns from a fund do not tell the whole story – the cost of the potential discount on the sale of a fund interest needs to be taken into account as well. In the current environment, private credit's self-liquidating nature presents a clear attraction.

Sources: Evercore, Full Year 2024 Secondary Market Survey Results; Morgan Stanley, 2024 Private Credit Outlook Considerations; Bain & Company, Private Equity Outlook 2025