Illiquidity, lock-ups and the liquidity premium

The single most important concept in alternatives is illiquidity — the difficulty of converting an asset back into cash quickly and at a fair price. Misjudging it is the most common and most painful mistake.

A spectrum, not a switch

Liquidity runs along a wide spectrum:

• Highly liquid — gold ETFs, listed commodity funds: sell any trading day in seconds.
• Moderately liquid — physical gold, listed REITs: sellable, but with spreads, dealer margins or some delay.
• Deeply illiquid — private-equity and venture funds, direct real estate, collectibles: money can be tied up for years.

What a lock-up is

A lock-up is a contractual period during which you simply cannot withdraw your capital. Private-equity and venture funds commonly run 7 to 12 years. Hedge funds often impose a one-year lock-up plus gates (caps on how much can be redeemed at once) and redemption windows (you can only request your money quarterly, say, with notice). During market stress, funds can suspend redemptions entirely.

Capital calls — the other side

Many private funds do not take all your money up front. You commit an amount, and the fund calls it in instalments over the first years as it finds deals. You must keep cash ready to answer those calls, or face penalties.

The liquidity premium

Why accept all this? In theory, illiquid assets should pay a liquidity premium — extra expected return as compensation for locking your money away. Sometimes that premium is real and substantial; sometimes it is illusory, eaten by fees or by buying at the top of a cycle. Never assume the premium exists — demand evidence, and only ever lock up money you are certain you will not need.