The benefits and trade-off between yield and liquidity
This article will explore the benefits and detriments related to investing in publicly traded and non-publicly financial assets. Stocks and bonds are examples of publicly trade assets; promissory notes and real estate are not publicly traded. Both categories can be employed successfully, and both can be misused and misunderstood. The analogy of a tool box applies: the investor must be well acquainted with, and understand, the available tools in his investing tool box, and how to use each tool properly.
Marketability, Liquidity and Illiquidity (Non-liquidity) Defined
Marketability is a measure of the ability of an asset to be bought and sold. The ability to convert an asset to cash quickly is also known as “marketability.” Poor marketability reduces the value of an asset. Marketability is similar to liquidity, except that liquidity implies the value of the asset is preserved, whereas marketability indicates that the security can be bought and sold easily.
Liquidity is the degree to which an asset or security can be bought or sold in the market without affecting the asset’s price. Liquidity is characterized by a high level of trading activity. Assets that can be easily bought or sold are liquid assets.
An illiquid asset cannot be quickly converted into cash. Such investments include limited partnerships, real estate, and promissory notes that do not trade on exchanges.
The Challenge of Illiquid Assets
The combination of credit troubles, lack of credit information, poor trading conditions, and lack of transparency create major valuation challenges for non-traded assets. The inability to gather information has become a significant handicap. The absence of liquidity lowers the value of the asset by the illiquidity discount. All other things being equal, the more illiquid the asset is, the less value it has. Measuring this discount and applying it in valuations of illiquid assets has always been a challenge.
The Benefits of Illiquid Assets
Now we have learned of the detriments and challenges of investing in illiquid assets, let’s explore the positives, the benefits. The benefits are important, and often, off-set the challenges.
• Assets lacking liquidity and marketability offer higher yields
• Assets lacking liquidity and marketability offer less volatility and more stability
• Assets lacking liquidity and marketability are a better emotional fit for some investors
• Assets lacking liquidity and marketability fit some investor’s areas of personal expertise and knowledge-promissory note experts and real estate experts are examples
Valuing Illiquid Investments
The experienced judgment of the valuation expert is the key factor. Every valuation method has its shortcomings. Estimating an appropriate discount for illiquid asset requires judgment. Over the years, court cases have recognized the value of an appraiser’s judgment over mechanical applications of rules of thumb.
Some of the factors considered are: financial statements and credit ratings of the borrower, payment history, amount and nature of collateral security, repayment terms and conditions contained in the documents, term of the loan, economic outlook, amount of control of the asset, restrictions on transferability, and costs associated with collecting if default occurs.
It is important to consider all of these factors when selecting the appropriate discount for lack of marketability. While using these factors as a guide, the judgment of the appraiser remains the key.
Valuing illiquid and private investments is a “Judgment process”. It requires a sound methodology that:
• established and defensible theoretical framework
• uses methods accepted by investors trading similar assets
• uses market information that is both reliable and appropriate
Illiquid assets can be excellent investments for the right investor, who has bought at the right price and understands himself and the asset bought.