Segmentation, Illiquidity, and Returns

Renato Staub and Jeffrey Diermeier

Volume 1, Number 1, First Quarter 2003

When investing in alternative assets, such as private equity or natural resources – which may be “locked-up” for prolonged periods of time – the question of compensation for illiquidity becomes important. No rational investor will choose the illiquid over the liquid asset unless he gets compensated for his loss of flexibility. We derive two approaches to model illiquidity compensation. In contrast to the ones most commonly seen in the literature, our methods do not analyze trading-based gains, which cannot be realized as a result of illiquidity. Rather, we investigate the implications of illiquidity for a long-term investor.