A review of Nadauld, T. D., Sensoy, B. A., Vorkink, K., & Weisbach, M. S. (2019). The liquidity cost of private equity investments: Evidence from secondary market transactions. Journal of Financial Economics, 132(3), 158-181.
I. Research question and its importance
Drawing on the literature of transaction cost and market microstructure, this article aims to explain the magnitude and determinants of transaction costs in the secondary market for private equity stakes. Namely, the authors attempt to measure the average cost of transacting from both buyer and seller perspectives. There are three reasons the topic is important. First, as the illiquidity of private equity investments is among the most important risks that investors should consider when making these investments, it’s unclear to what extent the price premium is attributable to illiquidity. Thanks to the authors’ proprietary source, they have the access to a market where investors can buy and sell limited partner (LP) stakes in private equity funds. Hence, their work is amongst the first to answer this question with empirical evidence. Second, the access to data allows them to measure the value of a “haircut” that PE investors pay to exit their commitments. In other words, they investigate the different transaction costs borne by seller and buyer in the secondary market. Lastly, with the unique data availability, they present the composition of buyer and seller, their average payoff, and identify possible explanations. This article sheds light on the cost of illiquidity, and opens new opportunities for future research.
II. Method, finding, and limitation
The private data was reported from a leading intermediary in secondary market for PE stake. The authors hence use the cash flow distributions of the funds, to arrive the annualized returns to investors (i.e., IRR) who buy and sell the funds on the secondary market. Furthermore, they compute annualized public market equivalents (PMEs) for buyers and sellers to adjust for market-wide factors. Ordinary least squares regressions with fixed effects were employed to analyse the data. They find that, as in their sample, the market is one in which relatively flexible buyers earn returns by supplying liquidity to investors wishing to exit. The buyers in these transactions outperform sellers, indicating that buyers who purchase a fund through the secondary market and hold the fund to liquidation earn higher returns than sellers, on average. In brief, the transactions costs in this market appear to be borne primarily by the sellers, not the buyers.
III. Future research
The authors try to find explanation for the phenomenon observed from the data. Despite bringing valuable data to answer the research question, their cross-sectional comparison fails to make causal inference, although was not the authors’ intention. Since sellers (e.g., institutional investors) usually opt to exit prior to liquidation due to policy change, such as Solvency II, Basel III, and the Volcker rule, future research might exploit such exogenous shocks to evaluate the impact of compliance with regulatory considerations. For instance, by comparing the market affected by the new policy to another that is not, researcher can identify the impact of policy change over investor’s decision to exit. Yet, as was one of the main contributions of the paper, data availability is the key.