Liquidity and Alternative Investments: Managing Illiquidity in a Portfolio

Illiquid investments — those that cannot be sold quickly at a fair price — have historically offered higher returns than their liquid equivalents. This "illiquidity premium" is well-documented in private equity, private credit, real estate, and infrastructure. For investors with a long time horizon and genuine surplus capital, accepting illiquidity in exchange for higher expected returns is a rational trade.

But liquidity risk is frequently underestimated. Investors who need capital unexpectedly, who assumed they could exit an investment but cannot, or who invested in vehicles with complex redemption mechanisms often find themselves in difficult positions — sometimes forced to accept significant discounts to fair value or locked into an investment far longer than they intended.

This guide explains how liquidity risk works across different alternative asset classes, how to assess your own liquidity needs, and how to build a portfolio that takes on measured illiquidity without compromising your financial security.

What Is Liquidity Risk?

Liquidity risk has two related but distinct dimensions:

Market liquidity risk: the risk that you cannot sell an asset at close to its fair value because there is insufficient demand in the market. Publicly listed equities in large-cap indices are highly liquid — you can sell millions of pounds of stock with minimal price impact. A holding in a small unlisted company may have no buyers at all for months or years.

Funding liquidity risk: the risk that you cannot access your capital when you need it, even if the underlying asset is theoretically valuable. This is the risk that fund structures, lock-up periods, and redemption mechanisms can impose — your capital is tied up even though the underlying assets may be performing well.

The Illiquidity Premium

The case for accepting illiquidity is well-established. Long-run data suggests:

• Private equity has historically delivered returns of 3–5% above listed equity markets, though with significant variation by fund and vintage year
• Private credit (direct lending to mid-market companies) offers yield premiums of 2–4% over public high-yield bonds for similar credit quality
• Infrastructure (toll roads, airports, energy networks) offers stable, inflation-linked cash flows that are difficult to replicate in public markets
• Real estate (direct or via funds) can offer yield and capital appreciation unavailable in public property markets

These premiums compensate investors for: the inability to exit quickly, the complexity of assessing private valuations, the higher risk of permanent loss in less liquid markets, and the operational demands of managing illiquid assets.

Asset Classes and Their Liquidity Profiles

Private equity (PE). Closed-end fund structures with commitment periods of 5–7 years and total fund lives of 10–12 years. Capital is called as investment opportunities arise (capital calls) and returned as exits are realised. You cannot exit a PE fund early unless you sell on the secondary market — typically at a discount. Secondary PE has grown considerably as a liquidity tool but is not available at par.

Private credit / direct lending. Loan structures with defined maturities (typically 3–7 years). Less liquid than bonds — there is a secondary market for private loans but it is less deep than the public bond market. Open-ended private credit funds may offer quarterly or semi-annual redemption windows, subject to notice periods.

Infrastructure funds. Closed-end structures similar to PE, or open-ended vehicles with limited redemption windows. Infrastructure assets (concessions, utilities) have very long lives — the fund structure must reflect this.

Real estate funds. Property unit trusts and REITs cover a spectrum: listed REITs are fully liquid; closed-end property funds have defined life cycles; open-ended daily dealing property funds carry significant redemption risk (as was demonstrated in 2016 and 2020, when UK commercial property daily dealing funds suspended redemptions when investor demand exceeded liquidity).

Hedge funds. Lock-up periods of 12–24 months are common for new investments. Quarterly redemption at 30–90 days' notice is typical thereafter. Side pockets can trap illiquid assets separately from the redeemable portion.

Infrastructure debt. Long-dated loans secured on infrastructure assets. Very illiquid in secondary market.

Collectibles (art, wine, classic cars, watches). No organised secondary market in most cases. Sales are event-driven (auctions, private treaty). Cost of sale (commission, storage, insurance) reduces net realisation.

Assessing Your Own Liquidity Needs

Before investing in illiquid assets, you must honestly assess how much liquidity you genuinely need over your investment horizon.

Emergency reserve: all investors should maintain 6–12 months of living costs in cash or near-cash at all times. This is not investable capital — it is insurance.

Known future expenditures: school fees, mortgage redemptions, business investment commitments, planned property purchases — identify and schedule these. Capital needed within three years should not be invested in illiquid assets.

Contingency capital: unexpected large expenditure — health costs, legal disputes, business support — can arise. Build a cushion beyond your calculated needs.

Life stage: a 40-year-old with a 25-year horizon can tolerate much more illiquidity than a 65-year-old who needs portfolio income to be stable and accessible.

The "Liquidity Ladder" Approach

A useful framework divides the portfolio into tiers based on liquidity:

Tier 1 (Fully liquid, 0–1 year): cash, money market funds, short-dated government bonds, listed equities. Accessible within days at fair value. Sized to cover living costs, known commitments, and a contingency buffer.

Tier 2 (Semi-liquid, 1–3 years): listed bonds, public equity funds, daily-dealing balanced funds, open-ended real estate funds with notice periods. Accessible within months at close to fair value.

Tier 3 (Illiquid, 3+ years): private equity, private credit, closed-end infrastructure, direct real estate, hedge funds with long lock-ups. Capital committed for the long term.

The proportion allocated to each tier depends on the investor's circumstances. A rule of thumb sometimes used is: the total illiquid allocation (Tier 3) should not exceed 30–40% of the total portfolio for most HNW investors, rising to perhaps 50% for larger investors with well-managed liquidity at other tiers.

Redemption Gates and Suspension

Even when an investment fund is marketed as "open-ended" or "liquid", unexpected conditions can trigger redemption restrictions:

• Redemption gates: limits on the proportion of the fund that can be redeemed in any given period (for example, 5% per quarter), which can delay full exit for months or years
• Suspension of dealing: the fund manager suspends redemptions entirely — as occurred in several UK commercial property funds in 2016 and 2020, and in some absolute return funds during market stress

These events are lawful. Investors should read fund prospectuses carefully and understand under what conditions redemption restrictions can be imposed. The fact that a fund has never restricted redemptions does not mean it cannot do so.

Diversification Within Illiquid Allocations

Illiquid investments concentrated in one vintage year, one sector, or one manager amplify rather than reduce risk. Diversification principles apply:

• Vintage year diversification: commit to private equity across multiple years to smooth the J-curve effect (the initial period of negative returns before exits materialise)
• Sector diversification: PE buyout, growth equity, private credit, and infrastructure have different return drivers
• Manager diversification: track record and manager selection is highly material in private markets
• Geography diversification: domestic and international private assets

How Global Investments Can Help

At Global Investments, we help HNW clients build portfolios that incorporate appropriate illiquid exposures without compromising their liquidity requirements. We can help you analyse your own liquidity needs, select funds and structures appropriate to your time horizon, and monitor your overall portfolio liquidity position over time. Investment values can fall as well as rise — and illiquid investments carry additional risks that require careful ongoing management.

This article is for general information only. Alternative investments are typically suitable only for sophisticated investors who can accept the risk of illiquidity and potential total loss. Past performance is not a guide to future returns. Always seek qualified professional advice before investing in illiquid asset classes.