Profits and the Tradeoff Between Yield and Liquidity
This article will explore the benefits and harms associated with investing in listed and unlisted financial assets. Stocks and bonds are examples of publicly traded assets; promissory notes and real estate are not publicly traded. Both categories can be successfully employed, and both can be misconstrued and misconstrued. The analogy of a toolbox applies: the investor should be well familiar with and understand the tools available in their investment toolbox and how to use each tool correctly.
Marketability, Liquidity and Illiquidity (Non-liquidity) Definition
Marketability is a measure of an asset’s ability to be bought and sold. The ability to turn an asset into cash quickly is also known as “marketability.” Poor marketability reduces the value of an asset. Marketability is similar to liquidity, except that liquidity implies that the value of the asset is preserved, while marketability indicates that the security can be easily bought and sold.
Liquidity is the degree to which an asset or security can be bought or sold in the market without affecting the price of the asset. Liquidity is characterized by a high level of trading activity. Assets that can be easily bought or sold are liquid assets.
Iliquidity (Not liquid)
An illiquid asset cannot be quickly converted to cash. Such investments include limited partnerships, real estate, and unlisted notes.
The challenge of illiquid assets
The combination of credit problems, lack of credit information, poor business conditions, and lack of transparency creates significant valuation challenges for non-marketable assets. The inability to collect information has become a major handicap. The lack of liquidity reduces the value of the asset due to the liquidity discount. Other things being equal, the less liquid the asset is, the less value it has. Measuring this discount and applying it to valuations of illiquid assets has always been a challenge.
The benefits of illiquid assets
Now that we’ve learned about the drawbacks and challenges of investing in illiquid assets, let’s explore the positives, the benefits. The benefits are significant and often outweigh the challenges.
• Assets that lack liquidity and tradability offer higher returns
• Assets that lack liquidity and tradability offer less volatility and more stability
• Assets that lack liquidity and marketability are a better emotional fit for some investors
• Assets that lack liquidity and marketability fit into the areas of personal knowledge and experience of some investors: note experts and real estate experts are examples.
Valuation of illiquid investments
The experienced judgment of the appraisal expert is the key factor. Each valuation method has its flaws. Estimating an appropriate discount for illiquid assets requires judgment. Over the years, court cases have recognized the value of an appraiser’s judgment on the mechanical applications of rules of thumb.
Some of the factors considered are: the borrower’s financial statements and credit ratings, payment history, amount and nature of collateral, payment terms and conditions contained in the documents, loan term, economic outlook, amount of control of the asset, restrictions on transferability, and costs associated with collection in the event of default.
It is important to consider all of these factors when selecting the appropriate non-marketability discount. When using these factors as a guide, the appraiser’s judgment remains the key.
The valuation of private and illiquid investments is a “judgment process.” It requires a robust methodology that:
• established and defensible theoretical framework
• uses methods accepted by investors who trade similar assets
• uses market information that is reliable and appropriate
Illiquid assets can be excellent investments for the right investor, who has bought at the right price and understands himself and the purchased asset.