Less liquid assets: Meaning, Criticisms & Real-World Uses

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What Are Less Liquid Assets?

Less liquid assets are investments that cannot be easily or quickly converted into cash without a significant loss in value. This characteristic, central to the concept of liquidity, is a key consideration within portfolio theory, impacting how investors manage their investment portfolio and allocate assets. Unlike highly liquid assets such as cash or publicly traded stocks, less liquid assets typically require more time and effort to sell, often involving specialized markets or a smaller pool of potential buyers. The degree of illiquidity can vary widely, from real estate that might take months to sell, to private equity stakes that could be tied up for years.

History and Origin

The concept of asset liquidity has been fundamental to financial markets for centuries, but the specific focus on "less liquid assets" as a distinct investment category has gained prominence with the evolution of global capital markets and the increasing complexity of financial instruments. Historically, assets like land and physical commodities were inherently illiquid. However, the rise of modern finance brought about organized exchanges and the standardization of securities, making many investments more easily tradable.

The Global Financial Crisis of 2008 highlighted the critical importance of liquidity, as a sudden freezing of credit markets exposed vulnerabilities stemming from illiquid holdings and complex financial products. Central banks, like the Federal Reserve, responded by implementing various measures to improve market liquidity and overall market functioning, including expanding the types of eligible collateral for lending facilities.¹⁰,⁹ This period underscored the systemic risks associated with a lack of liquidity, leading to increased scrutiny and regulatory attention on less liquid assets. The International Monetary Fund (IMF) regularly assesses global financial stability, often highlighting risks related to market and liquidity conditions.⁸,⁷

Key Takeaways

Less liquid assets are challenging to convert to cash quickly without a significant loss in value.
They often include investments such as private equity, real estate, and certain types of debt.
Investors typically demand an illiquidity premium, or higher potential returns, to compensate for the inability to easily access their capital.
The valuation of less liquid assets can be complex and less transparent compared to publicly traded securities.
Managing a portfolio with a significant allocation to less liquid assets requires careful planning for potential cash flow needs and a longer investment horizon.

Formula and Calculation

There isn't a single universal formula to calculate the "illiquidity" of an asset, as it's a qualitative characteristic rather than a precise quantitative measure. However, market participants often consider factors that influence the ease and cost of converting an asset into cash. These factors are often reflected in models that calculate a liquidity premium or discount.

One common way to conceptualize the cost of illiquidity is through a theoretical "liquidity discount" applied to an asset's intrinsic value. If a highly liquid comparable asset trades at price (P_L) and a less liquid asset with similar fundamentals trades at (P_{IL}), the liquidity discount ((D_L)) could be expressed as:

D_L = \frac{P_L - P_{IL}}{P_L}

This discount represents the percentage reduction in value an investor might accept to quickly sell a less liquid asset compared to a similar liquid one. Factors influencing this discount include market depth and transaction costs.

Interpreting Less Liquid Assets

Interpreting less liquid assets involves understanding the trade-off between potential higher returns and reduced flexibility. Investors acquiring these assets typically seek an "illiquidity premium," which is an additional return expected as compensation for the inability to readily sell the asset. This premium is a form of risk-adjusted return that acknowledges the inherent challenges.

The lack of a readily available secondary market for many less liquid assets means their valuation is often based on models and appraisals rather than real-time market prices. This can introduce subjectivity and make it more difficult for investors to accurately gauge their portfolio's true market value. Understanding the underlying drivers of the asset's value and the specific mechanisms for eventual exit (e.g., sale of a private company, maturity of a private debt instrument) is crucial when holding less liquid assets.

Hypothetical Example

Consider an investor, Sarah, who decides to allocate a portion of her portfolio to a direct investment in a small, privately held technology startup. This stake in the startup is a less liquid asset.

Initial Investment: Sarah invests $100,000 in the startup. There's no public exchange where she can sell her shares daily like publicly traded stocks.
Lack of Immediate Market: If Sarah suddenly needs $100,000 for an emergency, she cannot simply log into a brokerage account and sell her startup shares. Finding a buyer for her specific stake in a private company would require a private negotiation, which could take weeks or months.
Potential Discount for Speed: If she needed to sell quickly, she might have to offer her shares at a significant discount to their perceived value to entice a buyer, reflecting the illiquidity. This contrasts with a publicly traded company where she could likely sell shares at or near the current market price almost instantly.
Long-Term Horizon: Sarah's expectation is that the startup will grow substantially over 5-7 years, at which point it might be acquired by a larger company or go public through an initial public offering (IPO), providing a liquidity event for her investment. This illustrates the longer investment horizon typically associated with less liquid assets.

Practical Applications

Less liquid assets feature prominently in various investment strategies and financial planning contexts. They are commonly found in the portfolios of large institutional investors such as pension funds, endowments, and sovereign wealth funds, which have longer investment horizons and can tolerate periods of illiquidity. For example, UK pension funds have increasingly invested in harder-to-sell alternatives like property and infrastructure, though this can expose them to cash squeezes during market volatility.⁶ Similarly, some pension schemes consider how to manage illiquid assets when looking to transfer risk, such as through bulk annuity insurance premiums.⁵,⁴

Common examples include:

Private equity and venture capital: Investments in companies not listed on public markets. These often involve multi-year commitments.
Real estate: Direct ownership of properties or investments in private real estate funds. Selling real estate can be a lengthy process.
Private debt: Loans made directly to companies, often without a public trading market.
Hedge funds: Some hedge funds invest in illiquid strategies and may impose lock-up periods or redemption restrictions.
Collectibles: Art, rare coins, or other tangible assets whose value is highly subjective and for which finding a buyer can be challenging.

The SEC provides guidance on the illiquid nature of private placements, emphasizing that unlike investments purchased on a stock exchange, they are highly illiquid and investors may have difficulty reselling them.³

Limitations and Criticisms

While less liquid assets can offer the potential for enhanced returns, they come with significant limitations and criticisms. A primary concern is the reduced ability to access capital quickly, which can be problematic during unexpected financial needs or market downturns. This lack of liquidity can force investors to sell at a substantial discount if they need cash urgently, sometimes leading to significant losses.

Another criticism revolves around valuation transparency. Unlike publicly traded securities that have easily observable market prices, less liquid assets are often valued through complex models and appraisals, which can introduce subjectivity and potential for discrepancies. This opacity can make it difficult for investors to accurately assess the true value of their holdings and the performance of their diversification strategies. Furthermore, the limited secondary market for these assets means that exiting an investment can be slow and difficult, especially in stressed market conditions, as seen during periods of widespread illiquidity where finding buyers for certain assets became challenging.² The IMF's Global Financial Stability Report has highlighted how market volatility can be amplified by a deterioration in market liquidity.¹

Less Liquid Assets vs. Marketable Securities

The fundamental distinction between less liquid assets and marketable securities lies in their ease of conversion to cash.

Feature	Less Liquid Assets	Marketable Securities
Convertibility to Cash	Difficult and slow; often involves discounts	Easy and quick; can be sold at market prices
Trading Venue	Private transactions, limited secondary markets	Organized exchanges (e.g., stock markets, bond markets)
Valuation	Complex, relies on appraisals and models	Transparent, based on real-time market prices
Investment Horizon	Typically long-term (years)	Short- to medium-term
Typical Investors	Institutional investors, accredited investors, high-net-worth individuals	Retail investors, institutional investors, anyone with brokerage access
Examples	Private equity, direct real estate, private debt, collectibles	Stocks, bonds, mutual funds

Marketable securities, such as publicly traded stocks or government bonds, can be bought and sold quickly at prevailing market prices, offering high liquidity. Less liquid assets, conversely, lack this ready market, meaning a sale may require more time, effort, and potentially a price concession. This difference often leads to confusion, as both categories are part of an overall investment portfolio, but their practical implications for capital access are vastly different.

FAQs

What are some common examples of less liquid assets?

Common examples of less liquid assets include private equity investments, direct real estate holdings, private debt, venture capital funds, certain hedge fund strategies with redemption restrictions, and collectibles like art or rare antiques. These assets generally do not trade on public exchanges.

Why would an investor choose to invest in less liquid assets?

Investors choose less liquid assets primarily for the potential of higher risk-adjusted returns, often referred to as an "illiquidity premium," to compensate for the reduced ability to access their capital. They may also offer diversification benefits and exposure to unique growth opportunities not available in public markets.

Are less liquid assets suitable for all investors?

No, less liquid assets are generally not suitable for all investors. They are typically better suited for sophisticated investors, such as institutional investors or accredited investors, who have a long investment horizon, do not need immediate access to their capital, and can withstand the higher risks and complexities associated with these investments. Retail investors should carefully consider the risks.

How is the value of a less liquid asset determined?

The valuation of a less liquid asset is often determined through appraisals, financial models (such as discounted cash flow analysis), and comparisons to similar private transactions. Unlike publicly traded assets, there isn't a continuous market price. These valuations are typically performed periodically, such as quarterly or annually, rather than daily.

What are the main risks associated with less liquid assets?

The main risks include the inability to sell quickly without a significant price concession, difficulty in accurately valuing the asset due to lack of transparent market pricing, potential for higher transaction costs when selling, and a longer commitment of capital. These factors can lead to challenges in managing cash flow and rebalancing an investment portfolio.