The complexity premium: what is it and how does it work?

The “illiquidity premium” has long dominated conversations about returns in private assets. But while it remains important, we think investor understanding of private markets returns should evolve. In the coming weeks, we will be exploring the concept of “complexity premium” in a series of articles.

Do investors really need to get paid to invest into private assets?

The idea of the illiquidity premium implies that unless investors are paid for accepting illiquidity, they would not do so. However, expected outperformance is not the only benefit that private assets provide. There is also a lower actual volatility, diversification opportunities and the possibility to achieve sustainability and impact targets.

Is there a risk premium or a skill premium?

If there is outperformance in a private asset strategy or in a single investment, the standard explanation would be that investors have taken on more risk (in the form of illiquidity or other risks). The higher risk leads to lower entry valuations and thus to better performance; the compensation for the risks taken.

In this theoretical model, whether the risk materialises or not is explained by statistics. However, numerous real life investment examples make clear that the difference in performance delivered by private assets cannot only by explained by luck and random events. Instead, it is to a large degree decided by skill advantages that some managers have over others. A more appropriate description is to explain private asset returns as a combination of risk factors and skills advantages.

Skill differences are generally more pronounced in private assets than for listed investments, as access to investments and information is generally much more limited. Investors also take a much more active role in sourcing, accessing, negotiating, transforming and exiting an investment on the private asset side. Within private assets, skill differences become especially pronounced in what we call the “long tail” of investment opportunities – the vast majority of transactions have smaller deal sizes and are sourced in less efficient markets.

The complexity premium

In our view, return premia can be captured in private assets when two factors meet.

• First a situation arises that is particularly complex in terms of access, risks and opportunities.
• Second, rare skills are deployed to source, select and negotiate, develop and exit the investment.

The nature of the complexity premium differs depending on the type of asset, but both of these things are needed for it to emerge. A complex situation without the appropriate skills to engage with it successfully cannot offer the possibility to capture a complexity premium.

Sources of private asset complexity premium

The below graphic breaks down different sources of the complexity premium along the investment process. They describe complexities of a private asset investment that can contribute to value generation if matched by the appropriate skills.

No two investments are the same in how they might capture a complexity premium. We highlight two examples from different private asset classes to illustrate the concept, and how a complexity premium might be captured in different ways.

Example 1 - Private equity investment in a residential care home

Let’s take an example from our private equity team. It sourced a co-investment opportunity in a residential care home through a close primary investment relationship and selected it based on prior experience with a similar business model. The fund manager demonstrated specialist skills in developing the company, by further improving the quality of care, which benefited all patients and increased revenues. This was achieved by among other things, better utilisation and the opening of additional care facilities. This ultimately laid the ground for a successful exit. None of these drivers of complexity premium relate to liquidity.

Example 2 - Investment in a London office building

In another example, our real estate team had identified an opportunity with a distressed seller to acquire an office building in the Old Street area of London. This is an area they expected to rise in attractiveness for tenants from the tech sector. The team initiated extensive refurbishment work - including improving the building’s energy efficiency - and pre-let most of the building to two growing tech and marketing companies before construction was completed. The Old Street area of London has emerged as a growing tech hub and has, accordingly, attracted increased investor interest.

This is another example how the value creation process creates illiquidity, not the other way round.