Lil is short for little. It was originally a direct and intimate name for black people, just like your friends call you Xiao Li, Xiao Zhang, and Xiao Wang. Because hiphop first came from black neighborhoods, many of the earliest rappers kept their names as lil xxx. It became one. (note that you must press search lots of books after clicking on the link.) and since lil is a very popular name (both as. Ngram shows li'l beating out lil' and li'l' since before 1900.
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