Tough markets like those we are experiencing now get everyone nervous and looking to their liquid assets for comfort and opportunity. That is why investors, beforehand, should think about their liquidity needs. Illiquidity means different things to different people. There are two main ways to think about illiquidity. The first is from a practical perspective. Illiquidity means investing in an asset which cannot, or will be prohibitively difficult, to liquidate. James Osborne at Bason Asset Management talks about investors need to get liquid before they can get illiquid. He writes:
It’s okay if you want to own a rental property or two if you want to go in on a deal with your brother-in-law’s new company but FIRST you need to have sufficient liquid investments. I don’t believe there are any golden ratios here but you need to have real liquid, available, publicly traded assets before you start tinkering with stuff you can’t sell quickly. You should also beware any illiquid investment brought to your attention by a third party.
The latter point is important because we should not confuse illiquid assets and those sold to use by third parties that are illiquid due to their need to pay off the broker. In my book I wrote this about illiquid assets:
For individual investors, most illiquid assets come along with the twin challenges of high costs and high complexity. Most illiquid investments sold to individuals are designed that way so that the salesperson can be paid a commission. These investments are sold to investors, as opposed to being purchased. Investment manager and blogger David Merkel makes three important points about illiquid investments: “Illiquidity means a loss of flexibility. . . . The costs of illiquidity are quiet. The extra yield seems free until there is a need for ready cash, whether to spend or to take advantage of investment bargains…[and illiquid investments] are hard to evaluate unless you have expertise greater than that of the seller.”
Michael Kitces at Nerd’s Eye View has a great post up that discusses illiquidity and making sure that taking on that risk is justified. Kitces correctly notes that investors should only purchase illiquid assets if they are transparent in nature and that they be purchased through a fiduciary, not a salesperson. Kitces writes:
But most of all, it’s important to understand that the mere fact an investment has greater risk does not automatically entitle the investor to superior returns (just ask any casino or lottery ticket seller!). Similarly, an investment that happens to be illiquid doesn’t automatically entitle the investor to higher returns either. The illiquidity premium only applies when it is stacked on top of an otherwise sound investment. Otherwise, investing into illiquidity simply locks the investor into a potentially high-cost investment from which there is no feasible exit!
Kitces notes there is a potential return to illiquidity. This is the second way in which investors talk about it. The first way to think about an illiquidity premium is the return one gets by committing to a strategy over the a long-term time horizon. Locking up one’s money over time can lead to higher returns. The Blackstone Group in a research paper talks about how “patient capital” is better able to take advantage of certain opportunities in private companies, real estate and investment strategies.
Another way of thinking about illiquidity is a return one might be able to garner in the public markets. Roger Ibbotson et al. in a Financial Analysts Journal article write about liquidity as a distinct “investment style” separate and apart from value, size and momentum. They talk about how liquidity is easily measured and an intuitive factor that investors might take into account when constructing a portfolio.
I don’t know whether there is a illiquidity premium or not. It is certainly the case that investing in strategies like private equity and venture capital envision a time horizon that stretches into the years if not decades. An investor can only take on that kind of risk if, and only if, they already have a sufficient cash cushion built up to carry them through difficult times, which we are now experiencing.