Opportunity in illiquid investments

All types of assets in the same asset class are not created equal. Although in general, markets tend to be more or less efficient (at least if you can wait by the river long enough), there are peculiarities in the efficiency. One of the most prominent of these peculiarities is the liquidity premium.

The liquidity premium

While, ceteris paribus, liquidity is always preferable to illiquidity, it doesn’t mean that all liquid investments are always better than illiquid ones. Simply put, most of the money in almost any asset market is managed by a middleman – a professional money manager. This can mean mutual funds, REITs, pension plans, ETFs, hedge funds, private equity funds, etc. Regardless of size or scope of the pool of capital managed, the professional money manager tends to have either strong guidelines in the mandate or “character building experiences” in the past, managing an unstable pool of capital. These externally or self-imposed rules limit the manager to liquid or at the very least, most liquid assets in any given asset class. The harshness of liquidity restrictions also tends to correlate to the amount of money managed, ie a $100B fund will almost always have harsher rules than a $100M one. What this all amounts to: illiquid assets have FAR less competition from buyers, so they’re cheaper. Being a single bidder for an asset gets you a better deal than competing with several other bidders.

Sometimes it pays to be on the illiquid side

Being able to afford illiquid investments is a relative luxury in the world of investing, for reasons mentioned above. In conjunction with good money management, it can work wonders for you. Knowing that you can freely lock up capital for a decade or more, automatically eliminates almost every money manager out there from competition and leaves you competing with only other capital allocators like you and maybe a few fools. But the latter are unavoidable and tend to end up being the sellers looking for a bid a few years down the line, usually during or after macroeconomic shocks.

What kind of assets tend to be illiquid?

In the stock & bond markets, it’s fairly straightforward – smallcaps and emerging market stocks tend to be less liquid than largecaps and developed market instruments. In bonds, lower rating tends to mean less liquidity. What kind of other assets tend to be illiquid and why, depends on a multitude of factors. In intellectual property, it can be that the concept seems strange and the mechanics of purchase and enforcement are too obscure. In real estate, it can be a lot of things. Maybe, in a given area, there are no commercial real estate investment trusts that buy medium sized quality properties. Or, because of temporary and regional issues, there is very little competition for farmland sale & leaseback deals. Or, that infrastructure leases are relatively obscure to most people and therefore bidders are scarce.

A long term capital allocator can find ways to outperform competition if money management is solid and one is willing to look under rocks rarely touched.

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