Illiquidity Premiums and Investor Psychology

An illiquidity premium the concept that an investor will require additional return for holding or acquiring an investment that cannot be easily sold. A liquidity premium by contrast is additional value an investor would be willing to give up for an investment that could be easily sold.

As economic concepts the central idea is that a buyer may otherwise require a premium, or superior return, to hold an asset for an extended period of time without being able to sell or exchange it in a short timeframe. Private equity firms are notorious for locking up capital for extended periods of time, decades and in some cases even longer. The author is aware of one fund that locks up capital for more than half a century.

In reality, most investors engaging in activities requiring a supposed illiquidity premium are engaging in some form of high finance activity. By participating with a private equity or specialized fund they may also be speculating. What difference is the liquidity premium going to make in aggregate returns for the buy and hold investor in public equities if their ideas are correct and they can hold to their convictions, and literally hold onto their assets long term.

Be reminded of the phrase that there is no such thing as a free lunch. Investment returns are not created ex-nihilo but as a result of efficient deployments of capital in the form of debt or equity.

It should not be advocated that considerations about liquidity are not important. Crisis where liquidity is needed occurs at the worst and most unexpected times right in line with Murphy’s law.

However, if an investor requires an illiquidity premium for their investment in a particular asset, perhaps their opportunity cost as an investor is not rightfully formed. In the best of times, conservative business acquisitions, for example, occur rather infrequently. For some of the very best managers it has been observed to occur at the pace one or two every two years.

An investor who believes that they need a premium on a particular investment only nominally above market premiums may not understand that opportunity cost, just like a crisis, may cause change unexpectedly.

Continuing the free lunch theme, the aggregate value gained by an investor choosing to place their money with a mutual fund or investment manager will be the return of that investment minus the fees charged. There is also always premium imposed by the market. In layman’s terms if I go to the horse track to place a bet on the horses, the house has to get their cut to place the bet.

To bring the analogy closer to investing, consider that even discount brokerages like Vanguard, Fidelity, and the like will charge a nominal fee to allow market participation. While those fees are decreasing with increased competition they are still substantial in aggregate. The fee for participation in otherwise illiquid investments is almost always an order of magnitude greater than discount broker intermediary market participation. The consequence is that investors should be asking themselves a different, or at least broader set of questions.

First, it is not unreasonable, even for enterprising investors, to entrust a portion of their capital to capable, long term and value and growth oriented investment professionals or management teams. Afterall, the market is comprised of leading firms in whom direct capital is being allocated in the form of equity. CEOs are managing money in the trillions. Market indexes are passively following these managers. All while Adam Smith’s invisible hand is still busy after all these years via competition.

For investors considering an illiquid investment, the questions to be asked should be much broader. A starting point for critical examination of an illiquid investment should at a minimum include:

• Is this capital going to be put to its highest and best use?
• Will a greater opportunity for the capital be available in the next few years that I will have the knowledge and conviction to act on in the next few years?
• Is this particular investment high enough conviction that I would be willing to leave my capital in it for longer than a decade if required?
• In the case of an illiquid investment are the additional management fees and illiquidity result in an inadequate return compared to other investment opportunities?

If an investor cannot answer the above for a given investment it would be best for them to not to invest.

A final and perhaps more interesting question surrounding the idea of a illiquidity premium intersects the subject of psychology, economics and business cycles. The problem of illiquidity should be inverted. Could there be an advantage to investing in assets that are not liquid?

For most, the marginal investor. The answer is a firm no. For investors with the proper temperament, the answer is a strong probably. Down market investments, in smaller assets can allow for outside returns for a simple reason that they do not bear such heavy intermediary costs and can be acquired attractive prices relative to their value. The universe of opportunities is literally the largest among smaller investments.

It should be noted that investors participating in public markets pay hidden premiums for investing the companies participating in markets generally. These fees are over and above the price to the ‘house’ mentioned above.

A company’s ability to access public markets has tremendous benefits from increased visibility to the ability to raise capital. But public companies are required by law to undergo expensive, perpetual audits of their financials, and controls among a handful of additional requirements. Private firms by contrast bear no such additional costs. Similarly, public issue bonds are underwritten by a bank or reputable institution that charges a substantial fee to market the debt. The contrast between private and public companies a major expense.

Unless technological innovation comes along to reduce these audit costs, only the largest firms will benefit from market participation or be able to afford it. Profit incentives will likely produce some solutions to this problem in the not too distant future. Assuming an investment is more or less risky because it is liquid or illiquid is a misunderstanding of risk.

The misunderstanding about the nature of risk likely finds its way into the mindset of investors in a variety of ways. The leading false association - confusing volatility for risk. Nature or nurture the misconception results in poor investment decision making.

A key aspect of risk is actually formulated in how long you hold an appropriate investment. Consider brands like Coca-cola, Costco, Herseys or Nike. Their fundamental value proposition to the market is not likely to be disrupted in any short order. Risk may enter the equation as a result of the short term volatility of the market price of the company. The underlying value of the company is not likely to change all that much year to year.

Coca Cola stock might be very risky if bought for a day trade or to hold for only a week. But, purchased at a fair price relative to future cashflows and held over a 5 or 10 year period it probably has almost no risk at all. Buffett famously sums up the difference between volatility and risk as follows.

Finance departments believe that volatility equals risk. They want to measure risk, and they don't know how to do it, basically. So they said volatility measures risk. I've often used the example of the Washington Post's stock. When I first bought it in 1973 it had gone down almost 50%, from a valuation of the whole company of close to $170 million down to $80 million. Because it happened pretty fast, the beta of the stock had actually increased, and a professor would have told you that the company was more risky if you bought it for $80 million than if you bought it for $170 million. That's something I've thought about ever since they told me that 25 years ago and I still haven't figured it out.

- Warren Buffet

Illiquidity for an investment and the nature of short term risk from holding an investment for too short a period play out disastrously and spectacularly over market cycles. No one is more affected than the marginal investor. Interest rates can push asset prices to obscene levels by reducing or increasing the value of alternatives in the market. Mammalian susceptibility to herd mentality regularly leads investments into and out of otherwise sound investments at precisely the wrong time.

Evaluation of a potential investment requires proper consideration of where at any given time the market is likely to regress to a mean. Or if extreme irrationality is occurring in and around the investment considered. Investors should ‘know the future’ rather than speculate as to what it will be with regards to the particular investment.

Liquidity or illiquidity premiums should have no bearing on the merits of an investment. Assets purchased at discounts to their intrinsic value will always be a good investment. The only question for the investor is how does it compare to other options available at the time or in the near future? Will the investment lose money or make an inadequate return?

If the investment is superior to all other available options with a margin of safety then an illiquid investment can only be better or worse than a liquid investment of comparable characteristics.