Appearances can be deceiving
The 2008 Global Financial Crisis highlighted the importance of liquidity, whether you were a company or an individual investor. Holding assets that can be sold quickly at a price close to their stated value – typically cash or readily marketable securities – can prove invaluable during periods of stress. The lesson was painfully reinforced during the Global Financial Crisis and remains as relevant today as it was in 2008. Liquidity risk can be every bit as important as market risk.
As Oscar Wilde observed in The Importance of Being Earnest, appearances and reality are not always the same thing. Investing is no different. Assets can appear valuable, stable and low risk, but when circumstances change and money is needed, reality can intrude. Liquidity is often overlooked in good times and only appreciated when it disappears.
There are plenty of instances where illiquidity can be dangerous. Following the collapse of Lehman Brothers, management argued that the firm failed because of a run on liquidity rather than insolvency. More recently, Sam Bankman-Fried claimed that FTX “never went bankrupt” and instead suffered a liquidity crisis. The distinction is largely academic from the perspective of investors and creditors. Whether an institution fails because it lacks liquidity or because it is fundamentally insolvent, the outcome is often the same: capital is impaired and the business ceases to operate.
Illiquidity for large institutions like pension funds, endowments and major asset managers can be less of an issue than for private investors as they generally have predictable income streams, known liabilities and substantial reserves. They can afford to wait for markets to recover. Life rarely follows a predictable path for private investors, however. Divorce, illness, redundancy, tax liabilities, debt repayments and family emergencies can arise without warning. Liquidity is not merely a portfolio characteristic; it is insurance against becoming a forced seller.
The case of fund manager Neil Woodford provides a useful illustration of what can happen when liquidity fails and when an investor becomes a distressed seller. Woodford’s fund was suspended in 2019, and its assets were subsequently sold as part of the wind-down process. Woodford had bought preference shares in Sabina Estates, an unlisted Ibiza property developer, for €90m. Sabina bought these shares back for €50m, a 44% write-down on the most recent valuation, taking full advantage of the distressed sale process.
Liquidity gives an investor flexibility, but without it, investors may be compelled to sell at precisely the wrong time. Rational buyers will recognise their predicament and seek to exploit it, rendering irrelevant even independently audited valuations of illiquid investments.
The problem is compounded because many private investments appear less risky than they really are. Managers of private assets are often very good at smoothing returns. Some critics refer to this as “volatility washing”. On the way up, this creates an illusion of stability and lower risk. On the way down, though, there can be a mismatch between the estimated valuations and observed market transactions.
Investors should be aware that estimated net asset values (NAV) for illiquid investments are not the same thing as price. NAVs are an estimate. Price is what somebody is willing to pay when you want to sell. Fund NAVs and the price of their illiquid investments can frequently disconnect. Investors should also be aware that, during periods of market stress, funds may defer redemptions requests or impose gates, leaving capital tied up for longer than anticipated. Redemption rules can become more of a guide than law.
The true value of liquidity is flexibility. An investor with liquid investments and a cash reserve possesses options. They can rebalance, reduce risk, meet unexpected expenses and they can take advantage of opportunities created by market dislocations. An investor whose capital is locked away loses those options.
For this reason, calibrating a meaningful cash buffer is often one of the most valuable decisions an investor can make. Cash and easily saleable investments may appear unattractive compared with higher-returning private investments, but liquidity has real value because it allows investors to make decisions on their own terms and supports rational decision-making.
None of this means illiquid investments should be avoided entirely. As companies remain private for longer, private equity has become an increasingly important part of the investment universe, giving investors access to opportunities that may never reach public markets or only do so much later in their lifecycle. However, investors should recognise that they are giving up liquidity in exchange for higher expected returns. The appropriate premium remains open to debate. Some studies suggest 3-4% above public equity returns may be sufficient, while a study of 65,000 US service personnel found participants demanded a liquidity premium of 17% over public equities, implying an all-in required return of 25% before locking capital away.
Ultimately, private investors should view cash reserves and easily saleable investments not as a drag on returns but as a valuable option. If investors are going to lock up capital in illiquid investments, large institutions with predictable cash flows may be willing to accept a relatively modest illiquidity premium. Private investors, who generally have less certainty about their future cash flow needs, should arguably demand considerably more.
The distinction between apparent value and realisable value is easy to overlook during favourable market conditions. Assets that are rarely priced and infrequently traded can appear stable, predictable and highly valuable. However, value is only truly tested when an investor needs to sell. The investor with a diversified portfolio of liquid investments and a sensible cash buffer may earn slightly less in good times. However, they are also far less likely to be compelled to liquidate assets during periods of stress.
Over the long run, avoiding forced selling may prove more valuable than capturing the additional return promised by illiquid investments. As Wilde might have reminded us, when it comes to investing, the truth is rarely pure and never simple.
Please be aware that the value of investments may go up or down and you may receive back less than you invested originally. Past performance is not a guide to the future.
This document contains general information only and does not provide any advice or guidance specific to your personal circumstances.
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