22 Session 13: Liquidity Traps · Historical Performance of GE-LAV
| Unit | 3 — Decision and Application |
| Book Chapter | 6 (sections 6.7–6.10) |
| Track | Common core (both tracks) |
22.1 Learning Objectives
By the end of this session, students will be able to:
- Define a liquidity trap in the GE-LAV framework and distinguish it from a typical illiquidity event.
- Walk through the GE-LAV exit rule performance during three major historical episodes (GFC, COVID, 2022 rate shock).
- Identify the conditions under which the GE-LAV exit rule fails or under-performs.
- Connect the LP-level exit decision to the GP-level decision to extend or roll funds.
- Preview the Pigouvian exit tax as a corrective instrument (full treatment Session 24).
22.2 Pre-Class Assignment
- Read: Book Chapter 6, sections 6.7–6.10 (~10 pages)
- Optional: Review what your favorite institutional LP (CalPERS, CalSTRS, Yale, Harvard, your school endowment) did in 2008–2010 PE secondaries
22.3 In-Class Outline (75 minutes)
| Time | Segment | Format |
|---|---|---|
| 0:00–0:05 | Recap Session 12 · Today: empirical performance | Lecture |
| 0:05–0:20 | The liquidity trap, formally defined | Lecture |
| 0:20–0:40 | Three historical episodes — GFC, COVID, rate shock | Cases |
| 0:40–0:55 | When the GE-LAV rule fails | Lecture |
| 0:55–1:10 | LP-GP friction: extensions, continuation funds, NAV loans | Lecture + discussion |
| 1:10–1:15 | Tease: Pigouvian exit tax (full treatment Session 24) | Lecture |
22.4 Discussion Questions
- CalPERS sold ~$5B of PE secondaries in 2009 at substantial discounts. Reviewing the GE-LAV exit boundary and the conditions at the time, was this decision (a) optimal given their constraints, (b) suboptimal because they should have held, or (c) unanswerable without more context? Defend your answer.
- NAV loans have grown from <$1B in 2018 to >$40B in 2024. Is this a healthy development (LPs accessing liquidity without forced sales) or unhealthy (papering over real valuation issues)? Apply the GE-LAV lens.
- Some scholars argue the post-2022 “higher for longer” rate environment represents a permanent regime shift in \(\bar{L}\), not a stress event. If true, what’s the implication for OU calibration and exit boundary recommendations?
22.5 Worked Numerical Example: The 2008 Yale Decision
Setup (stylized, based on public disclosures): Yale endowment in Q4 2008. PE portfolio NAV: $3B. Public market drawdown has pushed PE allocation from target 25% to actual 35% of portfolio. Cash needs from operating budget: $200M.
Decision context: - Sell PE secondaries to raise cash and reduce allocation? - Hold and find cash elsewhere (e.g., new commitments paused)?
Step 1: GE-LAV exit boundary check
Yale’s PE portfolio is mixed-vintage, average 5 years remaining. \(L_t\) at Q4 2008: approximately −1.8.
Exit boundary at 5-year horizon: \(L^* \approx -1.2\) (PE buyout)
\(L_t = -1.8 < L^* = -1.2\) → Exit signal triggered
Step 2: What size of exit?
Forced exit pressure: need $200M cash + want to reduce $300M of allocation = $500M total
At 35% discount: would need to sell ~$770M of NAV to get $500M cash
Step 3: Counterfactual analysis
If Yale had held: - 2009: PE NAVs rose ~15% (mean reversion in \(L\)) - 2010: PE NAVs rose another 20% - The $770M of NAV held would have been worth ~$1.06B by 2010 - Net “missed value” from selling: ~$290M
If Yale sold (what they actually did, approximately): - $500M cash secured immediately - $270M of value sacrificed permanently - Allocation problem solved
Step 4: GE-LAV verdict
The exit signal triggered, but in retrospect, the magnitude of GE-LAV-optimal exit was smaller than what Yale executed. A more targeted exit (perhaps $300M instead of $770M of NAV) would have: - Raised needed cash + partial allocation reduction - Preserved more upside for the mean reversion - Net improvement vs. the all-in exit: ~$150M
22.6 What to Expect Next Session
Session 14 begins the portfolio construction topic (book Ch. 7). We’ll cover:
- Why portfolio allocation depends on liquidity state
- The Merton allocation as the no-liquidity-risk benchmark
- The liquidity hedge demand and its magnitude (~8 percentage points)
- The Merton-GE-LAV decomposition
Project proposal due at start of Session 14. Make sure your proposal is complete: asset selection, valuation question, methodology outline, data plan, track declaration.
Reading: Book Chapter 7, sections 7.1–7.3 (~10 pages).