Understanding Alternative Investment Assets in Detail

Have you ever tried to sell something quickly but couldn’t find a buyer? This can happen in the private markets too and it’s all about liquidity.

There are few things that are worse than wanting to cash out of an investment but not being able to. Imagine just having to sit back and watch the value of your portfolio changing with your hands tied.

This is why it is important to understand the liquidity and lock-in periods of the different asset classes before investing. In the public markets, this is a lot more straightforward. But, in the alternative investment space, liquidity is low, to say the least. Investors should be prepared to stay invested for longer periods of time.

In this chapter, we’re going to understand how liquidity and lock-in periods work for alternative investment assets and what investors should know.

In simple terms, liquidity is how easily you can turn your assets into cash. It’s like having something you can sell quickly without losing much value. In the context of alternative investments, liquidity varies significantly as compared to traditional assets like stocks and bonds.

For instance, on one end of the spectrum, we have cash, which is the most liquid asset. On the other end of the spectrum, we would probably have an asset like the house you live in.

When it comes to alternative assets, as you can imagine, the process of cashing out is a lot more complex. Let’s understand this with the help of an example.

Imagine you’re an artist and you have just come up with an idea for a revolutionary piece of work. But, like all great things, you will need quite a bit of time to complete this the way you want to.

After investing a few months of your time and undivided attention, you manage to complete the painting to your satisfaction. The value creation process is complete and you can now look for opportunities to exhibit the painting.

It takes a few more months to negotiate a contract with the largest art gallery in the country. Your opening exhibition attracts a fantastic crowd and you receive tremendous accolades and a number of offers for your painting. Riding the high of the success, you choose the buyer whose valuation seems most appropriate and you sell your work.

Now, would you have managed to create the same kind of value if you had only a week to create and sell the painting? Or if you had to quit midway?

Absolutely not!

Alternative assets work the same way. They take time to mature and realise their full potential, just like your painting. Apart from that, there is also a limited number of participants in the private markets. This means that the process of finding another buyer for the asset is a lengthy one. The valuation process, too, is quite complex and requires expert appraisal.

The illiquidity of PE/VC is partly due to the need for a period of time to create value. These are naturally long term assets. The other part of the reason is the technical one – they are not listed and traded everyday and there is no everyday price discovery mechanism.

The reason these assets are not listed goes back to the fact that they are in a growth-and-development phase. This is why they benefit from the lack of daily pressure of speculation on how the growth plan is going.

The public market values stability and predictability – it values meeting targets. If a company is in the growth phase it is almost impossible to predictably meet targets. This means that if it was listed, its shares would suffer massive volatility which would put the wrong type of pressure on founders trying to grow a new company.

This is why companies undergoing change benefit from being private.

Lock-in periods are like waiting times when you can’t sell or withdraw your investment. They’re common in different types of investments. Now, lock-in periods are quite common and they are present even in various public assets. For instance, fixed deposits and ELSS mutual funds are common examples.

In the case of alternative investments, however, they are even more crucial as they provide fund managers with stability and the time to execute long-term strategies without the pressure of sudden withdrawals.

The length of the lock-in period varies considerably with the different asset classes. This is primarily because of the differing nature of complexities.

For instance, private equity funds generally have a much longer lock-in period than hedge funds. This is because private equity investments typically need to gestate for longer. The portfolio companies need time to grow and create value.

This means that private equity funds have to stay invested or risk losing out on the potential gains. The last thing that they would require is investors who want to withdraw prematurely! Considering the large ticket size here, even if a small fraction of LPs want to exit, it can throw the entire portfolio out of balance and negatively impact all the other investors.

Private Equity:

Liquidity in private equity is characterized by long investment horizons, typically ranging from 5 to 10 years or more. During this period, investors’ capital is tied up in private companies, with no opportunity for early withdrawal. This illiquidity is due to the time required for private companies to mature and achieve significant growth or restructuring.

Lock-in periods in private equity are strict, often with no option for early exit. Investors must be prepared to have their capital committed for the entire duration of the fund’s lifecycle, which includes the time taken to identify investments, grow the companies, and then exit through a sale, merger, or IPO.

Venture Capital:

Venture capital is among the least liquid alternative asset classes, with long investment horizons typically required for startup companies to mature.

Lock-in periods in venture capital can extend for many years, as exits (via IPOs or acquisitions) usually occur only after the invested companies achieve significant growth and market penetration.

Real Estate:

In direct real estate investment, liquidity is generally low due to the time-consuming nature of selling properties, which includes finding buyers, negotiating deals, and completing legal processes.

Real estate funds typically have lock-in periods that can last several years, reflecting the time required to manage and exit real estate investments effectively. These funds often provide scheduled opportunities for redemption, but these can be limited and subject to fund performance and market conditions.

Hedge Funds:

Hedge funds can vary significantly in terms of liquidity, depending on their underlying assets and investment strategies. Some hedge funds invest in liquid assets and offer relatively shorter lock-in periods, while others focusing on long-term strategies may have longer lock-in periods.

The typical lock-in period for a hedge fund can range from a few months to several years. Investors in hedge funds need to carefully consider the fund’s liquidity terms, which dictate when they can redeem their investments.

Commodities:

Commodities as an asset class can offer higher liquidity, especially when traded on major exchanges as futures or other derivative contracts.

However, direct investment in physical commodities (like owning physical gold or agricultural products) comes with challenges in terms of storage, insurance, and transportation, making them less liquid compared to financialized commodities.

In India, the regulation of liquidity and lock-in periods is an important part of financial market oversight. This ensures that the markets run smoothly and protects investors.

SEBI and Liquidity Management

The Securities and Exchange Board of India (SEBI) sets rules for how liquid investments need to be. For example, mutual funds are required to have a certain level of liquid assets. This is to make sure that if a lot of investors want their money back at once, the fund can pay them without big issues.

Lock-In Periods in IPOs

SEBI also regulates lock-in periods, especially in Initial Public Offerings (IPOs) and certain funds. For IPOs, promoters and major shareholders often have to hold their shares for a certain time after the company goes public. This is to make sure they stay committed to the company and don’t just sell their shares quickly for a profit.

Regulations for Alternative Investments

For alternative investments like hedge funds, SEBI has set guidelines for lock-in periods. For instance, Category 1 and 2 AIFs are generally close-ended and they have a three-year lock-in period. However, please note that most VC/PE AIFs have lives of about 7-10 years, with extensions, and investors have no ability to request their money back earlier. This is to protect the fund and its investors. Because these funds often invest in things that are not easy to sell quickly, the lock-in periods help manage the selling process in an orderly way.