Liquidity and Illiquidity

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

To me, there were liquid investments such as equities or fixed income that could be sold in the market on a short-term basis. Everything else was illiquid.

That view changed pretty quickly when I joined the world of family offices. My first family office job was for one of Germany’s most famous tech entrepreneurs. For him, liquidity was not the function of whether an asset is tradeable, but of its quality: Focusing primarily on venture capital-backed start-ups, he had the view that he could always sell a stake in a well-performing start-up at a good price and on reasonably short notice.

For the same reasons, he was also skeptical of funds. Since they consist of worse-performing investments as well as well-performing investments, he saw them as harder to sell.

Legendary investor Seth Klarman of Baupost Group is another person who believes illiquid assets offer compelling opportunities. He explains his perspective in my favorite podcast, Capital Allocators:

• Illiquidity isn’t just dependent on whether an asset is tradeable or not, but on a lot of other factors. If you own a building, you can sell it whenever you want (although perhaps not always at an ideal price). If you own a quarter of the building, however, your stake becomes much more illiquid.
  

• Good illiquid assets can be more liquid at a better price than liquid ‘bad’ assets. A 10% stake in a publicly listed company that is struggling might be much harder to sell than an equal stake in a non-listed but well-performing company.
  

• Where there is illiquidity, there is opportunity. While investors should rightly be focused on long-term returns, things can pay off significantly if you can provide liquidity to a market or company during times of turmoil. Take the COVID market crash of 2020. As people rushed to sell assets without consideration for their underlying value, those who could provide liquidity to sellers were able to acquire assets at significant discounts.

As opinions have shifted towards favoring long-term investments and the endowment model, my own perspectives have evolved too. But still, where there is opportunity, there is risk. And the risks involved in tying up money for extended periods can be significant.

What is liquidity?

If you are ‘liquid’, it means you have sufficient easy-to-sell assets, such as cash or stocks, to meet your financial obligations. For private investors, those obligations come in many forms, ranging from essential living costs and mortgages to investment-related obligations, such as capital calls in private equity or venture capital funds.

Wealthier investors tend to face more challenges with liquidity, because of the types of assets they invest in. While retail investors are often limited to traditional investments such as funds or individual stocks, which can usually be liquidated at short notice, affluent investors may want to invest in real estate, PE and VC funds, or directly into companies. These are inherently illiquid investments, which either offer very limited liquidity, or which cannot be liquidated at all prior to the intended end of the investment horizon.

They are also less straightforward in terms of how capital is actually invested. If you want an ETF, you can just buy it. But if you want to invest in a fund, capital is called over time, which increases complexity.

A common school of thought — perhaps driven by the rise of the endowment model — is that you should maximize the percentage of illiquid investments in your portfolio. And I agree, to an extent. If you are not reliant on liquidity from your investments, it's almost irrational to not invest as much as you can into illiquid investments, provided that they (are expected to) offer higher returns than its liquid counterparts.

The problem is, many investors underestimate the challenges of liquidity.

The risks of illiquidity

Where do investors go wrong?

• They don’t know what they’re buying into. This might sound funny to experienced investors, but I have heard plenty of stories of investors committing significant amounts to PE or VC funds without realizing the fund might actually ask them to wire most or even all of that money. Maybe it’s a lack of understanding. Maybe they just forgot they had the commitment.
  

• They underestimate non-investment expenses. Investors may have a great understanding of their investment-related liquidity needs, such as expected capital calls and distributions, or their desired annual investments into a certain asset class. What they are less aware of is the other expenses they might have to consider. This can be operating costs, such as legal or accounting fees, for example. Or it could be private liquidity requirements: Especially when someone starts to invest after a windfall like selling a business, lifestyle costs tend to increase significantly as they reward themselves for years of hard work. Those private expenses rarely go back to their prior level, and they often also lose out on their prior salary when departing the company. As a result, they might burn through their liquid assets much more quickly than expected.
  

• They take too much risk in their liquidity management. With interest rates above zero again, fixed income and cash returns, while low relative to inflation, offer investors an attractive, lower-risk cash management option. However, for some, that is not enough. They want to maximize returns even on cash earmarked for future expenses, or try to minimize uninvested cash. That’s where things go wrong. If the markets see sudden drawdowns, or invested capital doesn’t return as quickly as expected, investors can be left needing to sell impaired assets, or might end up illiquid altogether.

Scrappy investors might not worry so much about liquidity risk. For those coming from entrepreneurial backgrounds, where cash tends to be more rare than not, finding liquidity in emergencies may already be second nature. You can always convince a supplier to extend a payment date by another week, or ask a client to pay in advance.

That might be more challenging in the world of investing, though, where a lack of liquidity can become a big problem very quickly.

Overleveraged liquid portfolios might trigger margin calls, where the investor is forced to cover the shortfall in as little as 72 hours. Unpaid capital calls might lead to penalty fees, or even the loss of prior paid-in capital. Or investors might simply not have the liquidity to capitalize on opportunities with short time windows.

There are two steps investors can take to mitigate liquidity risk.

• First, develop and maintain a detailed cash flow plan. Map out your personal expenses, business expenses and intended investments for the next 3-5 years. Evaluate which of those are certain (i.e. capital calls or a mortgage) and which are flexible (i.e. intended but uncommitted investments). Then, think about how market developments might affect your cash flow. What if the value of your liquid assets falls by 20% (which we even saw in ‘safe’ government bonds last year)? What if distributions from funds don’t come as intended? It’s better to consider worst-case scenarios ahead of time.

• Second, be realistic about how quickly your illiquid investment portfolio will grow. Many investors are impatient when it comes to illiquid investments, and rush to take outsized risks. Investments in PE and VC have incredible compounding effects once they reach the break-even point. But an investor only capitalizes on this if they actually get to that point. If you invest for the long-term, you should focus on the expected return potential of your illiquid investment portfolio over that time horizon, rather than the short-term returns on your earmarked safe investments.

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. Yet from my personal experience, proper liquidity management is something surprisingly few investors practice — especially among affluent investors, and even among some with their own family offices.

In previous editions of the newsletter, we looked at how to develop your Investment Objectives and how those might fit into the Aspirational Investor Framework. Through those exercises, you might have decided that illiquid asset classes are a good fit for your portfolio.

But heed my word: illiquid investments, such as PE or VC funds, can only achieve their promise of excess returns if you actually reach the steady-state of a diversified, established fund 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 or earmarked assets until they are needed for your illiquid investments. But don’t try to over-optimize. In my experience, the excess return of a few percentage points on a liquid asset does not justify the risk of endangering your illiquid investing strategy in its ramp-up phase.

Which also brings us back to Seth Klarman’s view of liquidity: If you end up being too illiquid to fund your existing investments, you may not only lose money there, but you will also suffer the opportunity cost of not being able to invest into new investments. Historically, alternative investment funds tend to fare worse going into a crisis, but perform well coming out of it. If you have no liquidity, you may miss out on these opportunities.

Liquidity isn’t something to underestimate, both in terms of risk and opportunity. It rewards the consistent, patient investor. Not the hasty one.

Liked what you read? Make sure to subscribe to not miss out on future newsletters. I write about topics covering the world of family offices, asset allocation, and alternative investments. And if you’re looking for hands-on help with your personal liquidity planning, don’t hesitate to reach out.