The Illiquidity Puzzle: Theory and Evidence from Private Equity

This paper presents a theory, where managers can use the liquidity of securities as a choice variable to screen for “deep pocket” investors, those that have a low likelihood of facing a liquidity shock. We assume that there is information asymmetry about the quality of the manager between the existing investors and the market. The manager then faces a “lemons” problem when he has to raise funds for a subsequent fund from outside investors, since the outsiders cannot determine whether the manager is of poor quality or the existing investors were hit by a liquidity shock. Thus, liquid investors can reduce the manager’s cost of capital in future fund-raising. We test the assumptions and predictions of our model in the context of the private equity industry. Consistent with the theory, we find that transfer restrictions on investors are less common in later funds organized by the same private equity firm, where information problems are presumably less severe. Also, partnerships whose investment focus is in industries with longer investment cycles display more transfer constraints. Finally, we present evidence consistent with the assumptions of our model, including the high degree of continuity in the investors of successive funds and the ability of sophisticated investors to anticipate funds that will have poor subsequent performance. ∗Harvard University and Massachusetts Institute of Technology. We thank a number of institutional and individual investors for making this paper possible by providing access to the limited partnership agreements in their files. Richard Testa helped us identify and access the Doriot papers discussed in Section 2. Helpful comments were provided by seminar participants at Harvard University, MIT, New York University, the Universities of Florida and Texas, Lucian Bebchuk, Katharina Lewellen, David Scharfstein, Jean Tirole, and a number of practitioners, especially Allan Bufferd, Rick Burnes, Peter Dolan, Tom Lupone, Ken Morse, Sarah Reed and Kevin Tunick. Matthew Espy, Chenling Zhang, and especially David Schannon provided excellent research assistance. Harvard Business School’s Division of Research provided financial support. All errors and omissions are our own. E-mail: [email protected]; [email protected].