Liquidity and Illiquidity

Welcome to this week’s edition of Cape May Wealth Weekly. If you’re new here, subscribe to ensure you receive my next piece in your inbox. If you want to read more of my posts, check out my archive. The first version of this post was published in February 2024.

When I left Goldman Sachs, I had a very binary view of liquidity. 

To me, there were liquid investments such as equities or fixed income, that we could sell on a daily (or maybe weekly) basis. Everything else was illiquid: Hard-to-sell private assets, such as private equity funds that we sold to our clients, that they would either have to sell through an internal marketplace with a discount, or that they would just hold through the 10+ year investment horizon.

When I joined the world of family offices, that view quickly changed. In my first family office job, I worked for one of Germany’s most famous tech entrepreneurs. His view of liquidity was very different: For him, illiquidity was not a function of the factual characteristics of an investment, for example if it’s publicly traded or not. Instead, liquidity (and illiquidity) was a function of the quality of an asset: Any good-enough asset - in his case, mostly stakes in leading venture capital-backed start-ups - could always be sold as needed to existing or outside investors, perhaps not with daily liquidity, but at reasonably short notice. Interestingly, that reason also was why he was skeptical of fund investments: Since they usually consist of both well-performing and less-performing investments rather than just the well-performing one, they are much harder to sell.

And accordingly, my view of liquidity and illiquidity has evolved as well.

What is liquidity, anyways?

Liquidity as a concept is simple - if you are “liquid”, it means that you have sufficient liquid assets, such as cash or stocks, to meet your obligations. Obligations can come in many shapes and forms, ranging from private expenses such as cost of living or a mortgage, to investment-related obligations such as capital calls of a private equity or venture capital fund.

Interestingly, liquidity tends to be more of an issue for affluent investors than retail investors given the larger universe of investable assets. Retail investors are more limited to traditional investments such as funds and ETFs, which can usually be liquidated at short notice, and even more speculative investments such as crypto or stock options are tradeable on a daily basis. Things are different for affluent investors: Investments such as real estate, PE and VC funds, or direct investments in companies, are inherently illiquid, and either offer only very limited liquidity, or might have no formal liquidity option until eventual liquidation of the investment.

One common point, perhaps driven by the continued rise of the Endowment Model, is that if you have a long-term time horizon, you should maximize the percentage of illiquid investments in your portfolio. And to a degree, I agree with this statement: If you are not dependent on liquidity from your investments, it's almost irrational to not invest as much as you can into illiquid investments, provided that you receive additional performance in return. (Perhaps anecdotally: I am always surprised when investors tell me that they don’t like illiquid investments given the long-term lock-up, but instead look to invest in public equities with an equally long time horizont.)

And yes, on paper, that point of view is true. But in practice, many investors underestimate the challenge of managing illiquid portfolios. Or in other words, they underestimate the challenges around liquidity.

The risks of illiquidity

Where do they go wrong?

• They don’t know what they’re buying. For investors experienced with alternative assets, it might almost sound funny - but more than once have I heard stories of investors committing significant amounts to private equity or venture capital funds without knowing that the fund might actually ask them to wire all of this money. Maybe it’s a lack of understanding - maybe they just forgot they had that commitment
  

• They underestimate non-investment expenses. In some cases, investors have a great understanding of their investment-related liquidity needs, such as expected capital calls and distributions or their desired annual investment into a certain asset class. However, one thing they are less aware of is their other expenses. Sometimes, it can be operating costs (think your legal or accounting fees). More often, it’s their private liquidity requirements. Especially when someone starts to invest after a successful exit, lifestyle costs tend to increase significantly - after all, they want to reward themselves for years of hard work. However, they rarely go back to their prior level, and often, they also lose their ongoing salary. Suddenly, they face substantial ongoing liquidity requirements, on top of investment-related commitments - and find themselves burning through liquid assets much more quickly than expected.
  

• They take too much risk in their liquidity management. In my last family office job, we started investing during the days of ZIRP, when you still had to pay negative interest on your cash balances, and when fixed income seemed like a terrible risk-reward given low returns and significant duration risk. Today, things look a bit rosier - fixed income  and cash returns, while low relative to inflation, offer investors a more attractive, lower-risk cash management option. However, for some, that is not enough. They want to maximize their return even on cash earmarked for future expenses, and/or try to minimize uninvested cash. And that’s where things go wrong: Markets might see sudden drawdowns, or invested capital might not return as quickly as expected, suddenly leaving investors in need of selling impaired assets at unfortunate moments or even leaving them entirely illiquid. (For more insights into this topic, see Liquidity Management for Fund Portfolios.)

Scrappy investors might not be worried so much about liquidity risk. Especially those coming from entrepreneurial backgrounds, where cash was scarce at times, finding liquidity in emergencies almost becomes a second nature. You can always get a supplier to extend their payment date by another week, or ask a client to pay in advance. However, in the world of investing, a lack of liquidity might become a problem on much shorter notice than elsewhere: Overleveraged liquid portfolios might bring margin calls that need to be solved in 72 hours. Unpaid capital calls might lead to penalty fees, or in some cases, even loss of prior paid-in capital. Or investors might simply not have the liquidity to capitalize on opportunities with short time windows.

So how do you mitigate liquidity risk?

First, by developing and maintaining a detailed cash flow plan. Map out your personal expenses, your business expenses, and your intended investments, for the next 3 to 5 years. Evaluate what of those expenses are certain (i.e. capital calls or a mortgage) and which are flexible (i.e. intended but uncommitted investments). Depending on jurisdiction, you should also take taxes into account (i.e. when you sell assets for your liquidity needs and/or rely on distributions from entity to private level). Then, think about how market developments might affect your cash flow: What if your liquid assets see a 20% drawdown (which we even had in “safe” government bonds in 2022)? What if distributions from funds don’t come as intended? As in other areas of investing, it’s better to consider worst-case scenarios ahead of time rather than when they happen.

Second, by being realistic about the ramp-up of your illiquid investment portfolio. Many investors are impatient when it comes to their illiquid investments, and take outsized risks in the “ramp-up” phase. Illiquid investments such as PE and VC have incredible compounding effects once they reach the fund portfolio “break-even”, but an investor only capitalizes on this if they actually get there. Accordingly, investors shouldn’t focus too much on short-term returns of the earmarked liquidity, but rather look at the long-term. Especially if you invest for the long-term, any short-term “underperformance” from safe investments should be quickly offset by the expected excess return of your illiquid investment portfolio.

In this regard, a personal anecdote: One of the family offices I’ve worked with over the years asked me about my return expectations on a fund portfolio. I personally feel quite good such a fund portfolio, in the absence of major economic turmoil, can achieve a 10% p.a. annualized return - but not from one day to the other: Given the aforementioned ramp-up phase, I told them that I’d personally expect a 10% annualized return for the 10-year period after the break-even point. A long time, without a doubt.

Capitalizing on illiquidity

So far, we’ve only talked about the risks of liquidity and illiquidity. However, this article wouldn’t be complete without showing the other side of the coin: The opportunity of being able to provide liquidity in times of turmoil. After all, in the world of investing, there are parties who base their entire strategy around providing liquidity to markets. Whether it’s the giant “quant trading” firms such as Citadel, or so-called secondary funds that help institutions rebalance their alternative investment portfolios - there is a clear opportunity to make money in providing investors with liquidity, when they need it.

In this regard, the best point on the matter that I heard comes from legendary investor Seth Klarman of Baupost Group, who was a guest last year on one of my favorite podcasts, Capital Allocators: 

• Illiquidity isn’t just dependent on whether an asset is tradeable or not, but on a lot of other factors. For example, if you own a building, you can sell it whenever you want (perhaps not at an ideal price) - but if you own ¼ of a building, your stake might be very illiquid. (My more venture-focused readers know the same is the case for a start-up. There’s few things more painful than owning a minority stake in a company whose founder is doing whatever they want.)

• Good illiquid assets can be more liquid at a better price than liquid “bad” assets. Another example from the world of venture capital: As my first family office job taught me, you can always sell a stake in a great start-up, while non-performers might not have any notable worth left anyway. It’s the average performers that are not clearly winning or losing, where it’s easy to get ‘trapped’. (That will be our topic for next week, stay tuned!).
  

• Liquidity is a significant return driver. Most investors should rightfully be focused on long-term, not short-term returns - but if you can provide liquidity to a market or company during times of turmoil, things can pay off significantly. For example, remember the COVID market crash of 2020: People started selling assets without consideration for underlying value, sometimes at ridiculously high discounts. Even “risk-free” assets such as US treasury bonds traded significantly below their typical values - so if you were able to provide liquidity to willing sellers, you were able to lock in returns significantly higher than what you’d normally expect from such assets.

Conclusion

Liquidity is something that is easy to forget about as long as it’s not an issue. But when liquidity turns into a problem, it very quickly becomes a big problem. From my personal experience, proper liquidity management is something that surprisingly few investors practice - especially among affluent investors, and even among some with their own family offices. There’s enough money to work with, until there’s not.

So for those that have developed their Investment Objectives and have come to the conclusion that illiquid asset classes might be a good fit for them, heed my word: Illiquid investments can only achieve their promise of excess return if you actually get them into their steady-state of a diversified, established portfolio. They are long-term investments by nature and by structure. 

On the way there, you might want to optimize your short-term return on cash until you can invest it into PE, VC, and other asset classes, and to a degree, that makes sense - you should always ask your bank for better terms one time too often. But don’t stretch it too far: From my experience, the excess return of a few percentage points does not justify the risk of endangering your illiquid investing strategy in its ramp-up phase.

Lastly, we can also look at this argument from the point of view of liquidity as a return driver. If you end up being too illiquid to fund your existing investments, you not only might lose money there, but also have the literal opportunity cost of not being able to invest into new investments. Historically, alternative investment funds have tended to fare worse going into a crisis, but also well coming out of a crisis - so if you have no liquidity to continue a fund program, you miss out on the upside, but also end up with a fund program that might have the worst vintage years of a cycle.

So don’t underestimate liquidity risk. Rather, see it as an opportunity: Rewarding the consistent, patient investor. Not the hasty one.

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