Love & Hate: Issue #2 - No Liquidity Premium

A CrossStack sub-blog on the good, the bad, and the ugly in the world of finance

Hate: 

When people tell me there’s only a tiny premium for illiquidity.

Much like cash, liquidity is king.  Without it, you are permanently “long” the risk.  There are no outs, and therefore no margin for error in the underwriting.

So when people tell me that an appropriate premium for something illiquid is something close to 100 basis points, it really grinds my gears. 

Incidentally, these are usually the same people who tell me that something is virtually risk-free.  I’ve learned to stop trying to guess the risks, and cut to the chase by simply asking: “it sounds amazing – so how do you lose money?”  (It usually turns out that some seemingly obscure risk is actually pretty material.)  Interestingly, often the risk is related to various forms of illiquidity.

The first type of illiquidity is on the asset itself:

• For example, say someone wanted to finance collectibles: things like baseball cards, sports jerseys, or $1 million cars.  Sure, there’s a vibrant market for these things on eBay and among specialty collectors.  And sure, you could sell a handful of these items on eBay and execute at pretty good prices.  And sure, you could show me data that you bought baseball cards at X price and sold it for X + Y. 

• But what if I had a $20 million loan collateralized by these collectibles… and it defaulted… and I had to take the collateral back… could I really dump $20 million worth of merchandise on eBay and sell it?  It might take me months, if not years.  Moreover, who’s managing that?

• I know, you’re going to tell me that some specialty items are very liquid, like Rolex watches.  I actually agree.  I’ve looked at financing these in the past and concluded that you could probably sell a $10 million duffle bag full of Rolexes and get decent execution.  But what about a $100 million truckload?  Or a $1 billion container full?

• Hence, the problem of illiquidity.  Stuff like that is valuable in small size (i.e., when market demand outweighs market supply), but could be a real problem in large size (i.e., when market supply outweighs market demand).  

• Now, I finance illiquid assets all day long.  But what you want in an illiquid asset is that it’s a self-liquidating asset – i.e., something that throws off cash flow.  Baseball cards don’t cashflow: you have to sell them to recoup your money.  But if an asset has cash flow (like a royalty stream, or an amortizing loan), you will get your money back just by sitting on it – you don’t have to monetize or sell it.  It creates its own liquidity as it converts to cash.

The second type of illiquidity is the type of security that you’re invested in.  This is where I get a lot of pushback.  Overly astute people say: “well, Treasuries are yielding 1%, and if you add on a risk premium of 5% for high-yield risk, and then a 1% premium for illiquidity, we believe that our cost of funds should be 7%.”  I politely tell them that if they have that deal available to them, they should absolutely take it.  Somehow, no one’s ever said that they do. 

• Consider this example: public market equities return 8%, yet private equity returns 15-20%.  Doesn’t this suggest an illiquidity premium of 7-12%?

• How about this one: high yield credit yields 5-8%, yet private direct lending yields 10-14%.  This implies an illiquidity premium of 5-6%.

• One more: REITs yield 5-6%, yet private real estate yields 12-15%.  This implies an illiquidity premium of 7-9%.

Does this seem high?  Think about this: I make a privately-negotiated, unrated, non-CUSIPed, non-tradable asset-backed loan to you secured by esoteric collateral, for which there is no broker-dealer willing to make a market.  How liquid is that instrument? 

Well, to paint the picture: there are probably fewer than 50 funds that seriously invest in private asset-backed loans.  Of those, probably fewer than 10 would invest in the type of esoteric collateral that I’m lending against.  This means that if I had to sell the loan for whatever reason, there are fewer than 10 people I can sell it to in the whole world!  That’s the definition of illiquidity.  Therefore, there’s a very real possibility I could be stuck with this loan forever, through thick and thin.  And if I ever needed to get out of it, there’s a good likelihood that those 10 fine firms would not buy me out at par, and I would have to sell at a discount.  This discount is another way of thinking about the premium for illiquidity.  And believe me, the discount would not be merely 100 basis points! 

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