{"concept_id":"ALTSS-PORT-017","slug":"illiquidity-premium","canonical_name":"Illiquidity Premium","aliases":["liquidity premium","illiquidity risk premium"],"kind":"term","authority":"academic","facets":["PCN","PRF"],"domains":["PORTFOLIO-CONSTRUCTION"],"display_title":"Illiquidity Premium","search_aliases":["what is the illiquidity premium","illiquidity premium private equity","does private equity earn an illiquidity premium","liquidity risk premium private equity","how big is the illiquidity premium"],"disambiguation":"In bond-market term-structure theory, \"liquidity premium\" also means the extra yield on longer maturities. This entry covers compensation for holding assets that are hard to sell.","one_sentence_definition":"The illiquidity premium is the additional expected return investors require, or are hypothesised to earn, for holding assets that cannot be sold quickly or without a material price concession, such as interests in private funds.","plain_english":"If two investments carry the same risk but one can be sold tomorrow and the other is locked up for ten years, investors should demand more from the locked-up one. That extra expected return is the illiquidity premium. It cannot be observed directly: private-markets returns mix it with leverage, sector exposure, manager skill and fees, and how large it is remains disputed.","parent_concepts":[],"child_concepts":[],"related_concepts":["liquidity-risk","public-market-equivalent","direct-alpha","return-smoothing","strategic-asset-allocation","alpha","dlom","secondary-pricing","performance-dispersion"],"comparison_concepts":[],"not_the_same_as":[{"slug":"dlom","distinction":"A DLOM is a valuation discount applied to a specific holding in some valuation contexts; the illiquidity premium is an expected-return concept."},{"slug":"alpha","distinction":"Alpha is return unexplained by the chosen risk factors. Whether private equity's excess return is alpha or a liquidity premium depends on whether a liquidity factor is in the model."},{"slug":"liquidity-risk","distinction":"Liquidity risk is the exposure; a liquidity risk premium is the compensation, if any, for bearing it."}],"formula_ids":[],"worked_examples":[],"sections":[{"heading":"Two ideas that share a name","paragraphs":["The term covers two related but different things.","- **Compensation for illiquidity of the asset.** The holder cannot trade when it wants to, or only at a high cost, and is assumed to require a higher expected return in exchange.\n- **Compensation for liquidity risk.** The asset's returns are exposed to market-wide liquidity shocks, which tend to hit when investors most need cash. Franzoni, Nowak and Phalippou (2012) found that private equity is exposed to the same liquidity risk factor as public equity and other alternatives; in their sample the unconditional liquidity risk premium was about 3% a year, and adding it to a four-factor model reduced private equity's alpha to zero.","An asset can be illiquid without being exposed to market-wide liquidity risk, and the reverse. Estimates of one do not measure the other."]},{"heading":"Why it is hard to estimate","paragraphs":["There is no traded price series for most private holdings, so every estimate rests on modelling choices.","- Reported returns are based on appraised NAVs that are lagged and smoothed ([return smoothing](/glossary/return-smoothing)), which understates volatility and correlation and flatters risk-adjusted comparisons.\n- Fund [IRR](/glossary/irr) is money-weighted; index returns are time-weighted. Comparisons need a method such as a [public market equivalent](/glossary/public-market-equivalent) (PME) or [direct alpha](/glossary/direct-alpha), and the answer depends on the index chosen.\n- Datasets differ in coverage and suffer from [survivorship bias](/glossary/survivorship-bias) and reporting bias.\n- Leverage, company size and sector tilts produce excess returns over a broad index that are not compensation for illiquidity.","The results conflict. In Harris, Jenkinson and Kaplan (2014) the average US buyout fund beat the S&P 500 by 20% to 27% over its life, more than 3% a year, while venture capital beat it in the 1990s and lagged it in the 2000s. Phalippou and Gottschalg (2009) instead reported average net-of-fee returns trailing the S&P 500 by 3% a year, or 6% after adjusting for risk, in their sample. Neither result is a measure of an illiquidity premium: outperformance against an index is not the same thing as compensation for being unable to sell."]},{"heading":"What theory says about the cost of illiquidity","paragraphs":["Ang, Papanikolaou and Westerfield (2014) model an investor who can trade an illiquid asset only at uncertain times. Illiquidity makes the investor behave as if more risk-averse and reduces holdings of both liquid and illiquid risky assets. Uncertainty about how long the asset stays untradable, rather than a known lock-up, is a primary determinant of the cost; in their calibration investors would give up about 2% of wealth to hedge against liquidity crises that occur once a decade. Sorensen, Wang and Yang (2014) find that management fees, carried interest and illiquidity together are costly to LPs, so GPs must generate substantial alpha for LPs to come out ahead, and standard performance measures may overstate the value LPs receive.","A practical implication: the cost of illiquidity is specific to the investor. An investor with a long horizon, stable inflows and a large liquid buffer bears it more cheaply than one that may need to sell in a crisis."]},{"heading":"How allocators use the concept","paragraphs":["In setting a [strategic asset allocation](/glossary/strategic-asset-allocation), capital market assumptions for private classes often add an assumed premium to a comparable public exposure. Many investors treat that premium as a hurdle the asset class must clear to justify the lost flexibility, not as a return they expect to receive automatically, and set the hurdle on a PME or direct-alpha basis so it can be tested against realised fund cash flows. The size of the assumed premium, and whether it is stated net of fees, should be disclosed with the assumption set."]},{"heading":"Illiquidity premium versus valuation discounts","paragraphs":["The premium is about expected returns. It is separate from discounts applied in valuation. Fair value under Accounting Standards Codification (ASC) Topic 820 in the US and International Financial Reporting Standard (IFRS) 13 is the price in an orderly transaction between market participants at the measurement date. The International Private Equity and Venture Capital Valuation (IPEV) Guidelines explain that the hypothetical marketing period is assumed to begin before the measurement date, so that the sale completes on that date, and on that basis state that a discount for marketability (the time needed to sell) is not appropriate in a fair value measurement. They do ask the valuer to consider the risk from a lack of liquidity when adjusting multiples taken from listed comparables, and describe calibration to the price of the initial investment as a way to assess it. A [discount for lack of marketability](/glossary/dlom) (DLOM) is used in other valuation contexts. Separately, prices in secondary sales of fund interests often sit below reported NAV, and the IPEV Guidelines note that secondary prices often include factors that may not be consistent with an orderly transaction, such as a seller's wish to rebalance its portfolio and a buyer's need to price in a required rate of return ([secondary pricing](/glossary/secondary-pricing))."]}],"classification_rules":[],"calculation_rules":[],"common_mistakes":["Treating a fund's IRR minus an index return as the illiquidity premium. The gap mixes leverage, sector, skill, fees, timing and measurement method.","Assuming the premium is earned simply by holding illiquid assets. Theory says investors should require it; it does not guarantee it is paid.","Using smoothed NAV-based volatility to show superior risk-adjusted returns for private assets.","Quoting a single figure as the consensus size of the premium. Published estimates depend on data, period and method and conflict.","Applying one investor's cost of illiquidity to another with different liquidity needs."],"edge_cases":["Semi-liquid evergreen funds offer periodic redemptions subject to limits, so the illiquidity being compensated is partial and can change under stress.","Secondary buyers can earn a return for providing liquidity by buying fund interests below NAV; that is a different trade from holding the primary commitment.","In private credit the spread over public loans mixes credit, complexity and illiquidity compensation; separating them needs assumptions."],"external_standard_mappings":[],"source_ids":["SRC-ACAD-ANG-PAPANIKOLAOU-WESTERFIELD-2014","SRC-ACAD-FRANZONI-NOWAK-PHALIPPOU-2012","SRC-ACAD-HARRIS-JENKINSON-KAPLAN-2014","SRC-ACAD-PHALIPPOU-GOTTSCHALG-2009","SRC-ACAD-SORENSEN-WANG-YANG-2014","SRC-INTL-IFRS-13","SRC-IPEV-2025","SRC-US-FASB-ASU-2011-04"],"citations":[{"source_id":"SRC-ACAD-FRANZONI-NOWAK-PHALIPPOU-2012","pinpoint":"Abstract","supports":"Private equity's exposure to the liquidity risk factor; liquidity risk premium about 3% a year; alpha falls to zero once included","source":{"source_id":"SRC-ACAD-FRANZONI-NOWAK-PHALIPPOU-2012","title":"Private Equity Performance and Liquidity Risk","authors":"Francesco Franzoni; Eric Nowak; Ludovic Phalippou","publisher":"The Journal of Finance","document_type":"paper","url":"https://doi.org/10.1111/j.1540-6261.2012.01788.x","doi":"10.1111/j.1540-6261.2012.01788.x","year":2012,"publication_date":"Vol. 67(6), pp. 2341-2373, published 19 November 2012","jurisdiction":"intl","status":"Published (paywalled)","last_verified":"2026-10-01"}},{"source_id":"SRC-ACAD-ANG-PAPANIKOLAOU-WESTERFIELD-2014","pinpoint":"Abstract","supports":"Cost of illiquidity driven by uncertain non-trading intervals; about 2% of wealth to hedge decennial liquidity crises (model calibration)","source":{"source_id":"SRC-ACAD-ANG-PAPANIKOLAOU-WESTERFIELD-2014","title":"Portfolio Choice with Illiquid Assets","authors":"Andrew Ang; Dimitris Papanikolaou; Mark M. Westerfield","publisher":"Management Science","document_type":"paper","url":"https://doi.org/10.1287/mnsc.2014.1986","doi":"10.1287/mnsc.2014.1986","year":2014,"publication_date":"Vol. 60(11), pp. 2737-2761, November 2014","jurisdiction":"intl","status":"Published (paywalled)","last_verified":"2026-10-01"}},{"source_id":"SRC-ACAD-SORENSEN-WANG-YANG-2014","pinpoint":"Abstract (NBER w19612)","supports":"Fees, carry and illiquidity are costly to LPs; GPs need substantial alpha; standard metrics may overstate LP value","source":{"source_id":"SRC-ACAD-SORENSEN-WANG-YANG-2014","title":"Valuing Private Equity","authors":"Morten Sorensen; Neng Wang; Jinqiang Yang","publisher":"The Review of Financial Studies","document_type":"paper","url":"https://www.nber.org/papers/w19612","year":2014,"publication_date":"NBER Working Paper 19612 (November 2013); published Review of Financial Studies 27(7):1977-2021 (2014)","jurisdiction":"intl","status":"Published","last_verified":"2026-10-01"}},{"source_id":"SRC-ACAD-HARRIS-JENKINSON-KAPLAN-2014","pinpoint":"Abstract","supports":"US buyout funds outperformed the S&P 500 by 20–27% over fund life; VC results by decade","source":{"source_id":"SRC-ACAD-HARRIS-JENKINSON-KAPLAN-2014","title":"Private Equity Performance: What Do We Know?","authors":"Robert S. Harris; Tim Jenkinson; Steven N. Kaplan","publisher":"The Journal of Finance","document_type":"paper","url":"https://doi.org/10.1111/jofi.12154","doi":"10.1111/jofi.12154","year":2014,"publication_date":"Vol. 69(5), pp. 1851-1882","jurisdiction":"intl","status":"Published (paywalled)","last_verified":"2026-10-01"}},{"source_id":"SRC-ACAD-PHALIPPOU-GOTTSCHALG-2009","pinpoint":"Abstract","supports":"Average net-of-fee performance 3% a year below the S&P 500 (6% risk-adjusted) in their sample","source":{"source_id":"SRC-ACAD-PHALIPPOU-GOTTSCHALG-2009","title":"The Performance of Private Equity Funds","authors":"Ludovic Phalippou; Oliver Gottschalg","publisher":"The Review of Financial Studies","document_type":"paper","url":"https://doi.org/10.1093/rfs/hhn014","doi":"10.1093/rfs/hhn014","year":2009,"publication_date":"Vol. 22(4), pp. 1747-1776","jurisdiction":"intl","status":"Published (paywalled)","last_verified":"2026-10-01"}},{"source_id":"SRC-IPEV-2025","pinpoint":"Section I 1 commentary (p. 10); Section I 2.6 commentary (p. 19); Section I 3.4 commentary, 'The impact of lack of Liquidity' and 'Calibration' (pp. 27-28); Section I 4.3 commentary (p. 50); Section III, 'Marketability' (p. 72)","supports":"Marketing period assumed to begin before the measurement date; no discount for marketability in fair value; lack-of-liquidity risk considered when adjusting comparable multiples, with calibration as a technique; secondary prices include factors not fully congruent with an orderly transaction","source":{"source_id":"SRC-IPEV-2025","title":"International Private Equity and Venture Capital Valuation Guidelines (2025 edition)","authors":"IPEV Board","publisher":"IPEV","document_type":"standard","url":"https://www.privateequityvaluation.com/Portals/0/Documents/Guidelines/2025%20IPEV%20Valuation%20Guidelines.pdf","year":2025,"publication_date":"Published 11 December 2025; in effect for quarterly reporting periods beginning on or after 1 April 2026; early adoption encouraged","jurisdiction":"intl","status":"Current; supersedes the December 2022 edition","last_verified":"2026-10-01"}},{"source_id":"SRC-US-FASB-ASU-2011-04","pinpoint":"ASC 820-10-35-2 as amended by ASU 2011-04","supports":"US GAAP fair value: price received to sell an asset in an orderly transaction between market participants at the measurement date","source":{"source_id":"SRC-US-FASB-ASU-2011-04","title":"ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs","publisher":"Financial Accounting Standards Board","document_type":"standard","url":"https://storage.fasb.org/ASU2011-04.pdf","publication_date":"May 2011","jurisdiction":"US","status":"in force (codified in ASC 820)","last_verified":"2026-10-01"}},{"source_id":"SRC-INTL-IFRS-13","pinpoint":"Standard summary page: definition of fair value","supports":"IFRS 13 fair value: price received to sell an asset in an orderly transaction between market participants at the measurement date","source":{"source_id":"SRC-INTL-IFRS-13","title":"IFRS 13 Fair Value Measurement","publisher":"IFRS Foundation / International Accounting Standards Board (IASB)","document_type":"standard","url":"https://www.ifrs.org/issued-standards/list-of-standards/ifrs-13-fair-value-measurement/","publication_date":"Issued May 2011 by the IASB; later consequential amendments (IAS 19 2011, Annual Improvements 2011-2013, IFRS 9 2014, IFRS 16 2016, IFRS 18 2024, IFRS 19 2024)","jurisdiction":"intl","status":"in force","last_verified":"2026-10-01"}}],"faq":[{"q":"How big is the illiquidity premium in private equity?","a":"There is no agreed figure. Franzoni, Nowak and Phalippou (2012) estimated a liquidity risk premium of about 3% a year in their sample, while studies of private equity's excess return over public markets reach conflicting conclusions depending on data, period and method."},{"q":"Does private equity outperform because of an illiquidity premium?","a":"Not demonstrably. Excess returns over an index can also come from leverage, sector and size exposure or manager skill, and some studies find no outperformance after fees. Isolating the part that pays for illiquidity requires a model and is contested."}],"seo":{},"first_published":null,"last_reviewed":"2026-10-02","last_modified":"2026-10-02","content_version":"2.0.0","url":"https://altss.com/glossary/illiquidity-premium","json_url":"https://altss.com/reference/concepts/illiquidity-premium.json","title":"Illiquidity Premium","formulas":[],"sources":[{"source_id":"SRC-ACAD-ANG-PAPANIKOLAOU-WESTERFIELD-2014","title":"Portfolio Choice with Illiquid Assets","authors":"Andrew Ang; Dimitris Papanikolaou; Mark M. Westerfield","publisher":"Management Science","document_type":"paper","url":"https://doi.org/10.1287/mnsc.2014.1986","doi":"10.1287/mnsc.2014.1986","year":2014,"publication_date":"Vol. 60(11), pp. 2737-2761, November 2014","jurisdiction":"intl","status":"Published (paywalled)","last_verified":"2026-10-01"},{"source_id":"SRC-ACAD-FRANZONI-NOWAK-PHALIPPOU-2012","title":"Private Equity Performance and Liquidity Risk","authors":"Francesco Franzoni; Eric Nowak; Ludovic Phalippou","publisher":"The Journal of Finance","document_type":"paper","url":"https://doi.org/10.1111/j.1540-6261.2012.01788.x","doi":"10.1111/j.1540-6261.2012.01788.x","year":2012,"publication_date":"Vol. 67(6), pp. 2341-2373, published 19 November 2012","jurisdiction":"intl","status":"Published (paywalled)","last_verified":"2026-10-01"},{"source_id":"SRC-ACAD-HARRIS-JENKINSON-KAPLAN-2014","title":"Private Equity Performance: What Do We Know?","authors":"Robert S. Harris; Tim Jenkinson; Steven N. Kaplan","publisher":"The Journal of Finance","document_type":"paper","url":"https://doi.org/10.1111/jofi.12154","doi":"10.1111/jofi.12154","year":2014,"publication_date":"Vol. 69(5), pp. 1851-1882","jurisdiction":"intl","status":"Published (paywalled)","last_verified":"2026-10-01"},{"source_id":"SRC-ACAD-PHALIPPOU-GOTTSCHALG-2009","title":"The Performance of Private Equity Funds","authors":"Ludovic Phalippou; Oliver Gottschalg","publisher":"The Review of Financial Studies","document_type":"paper","url":"https://doi.org/10.1093/rfs/hhn014","doi":"10.1093/rfs/hhn014","year":2009,"publication_date":"Vol. 22(4), pp. 1747-1776","jurisdiction":"intl","status":"Published (paywalled)","last_verified":"2026-10-01"},{"source_id":"SRC-ACAD-SORENSEN-WANG-YANG-2014","title":"Valuing Private Equity","authors":"Morten Sorensen; Neng Wang; Jinqiang Yang","publisher":"The Review of Financial Studies","document_type":"paper","url":"https://www.nber.org/papers/w19612","year":2014,"publication_date":"NBER Working Paper 19612 (November 2013); published Review of Financial Studies 27(7):1977-2021 (2014)","jurisdiction":"intl","status":"Published","last_verified":"2026-10-01"},{"source_id":"SRC-INTL-IFRS-13","title":"IFRS 13 Fair Value Measurement","publisher":"IFRS Foundation / International Accounting Standards Board (IASB)","document_type":"standard","url":"https://www.ifrs.org/issued-standards/list-of-standards/ifrs-13-fair-value-measurement/","publication_date":"Issued May 2011 by the IASB; later consequential amendments (IAS 19 2011, Annual Improvements 2011-2013, IFRS 9 2014, IFRS 16 2016, IFRS 18 2024, IFRS 19 2024)","jurisdiction":"intl","status":"in force","last_verified":"2026-10-01"},{"source_id":"SRC-IPEV-2025","title":"International Private Equity and Venture Capital Valuation Guidelines (2025 edition)","authors":"IPEV Board","publisher":"IPEV","document_type":"standard","url":"https://www.privateequityvaluation.com/Portals/0/Documents/Guidelines/2025%20IPEV%20Valuation%20Guidelines.pdf","year":2025,"publication_date":"Published 11 December 2025; in effect for quarterly reporting periods beginning on or after 1 April 2026; early adoption encouraged","jurisdiction":"intl","status":"Current; supersedes the December 2022 edition","last_verified":"2026-10-01"},{"source_id":"SRC-US-FASB-ASU-2011-04","title":"ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs","publisher":"Financial Accounting Standards Board","document_type":"standard","url":"https://storage.fasb.org/ASU2011-04.pdf","publication_date":"May 2011","jurisdiction":"US","status":"in force (codified in ASC 820)","last_verified":"2026-10-01"}]}