Opinion

Felix Salmon

The hunt for illiquidity

By Felix Salmon
May 25, 2012

When I spoke to Kauffman’s Diane Mulcahy, the main subject of conversation was her fabulous report on how investing in venture capital is broken. And I wondered whether investors’ consistent desire to throw money at the asset class, even after 15 years of consistent underperformance, was attributable to some kind of weird nostalgia for the 1990s, when the dot-com bubble briefly made a handful of VC investors very wealthy.

But there’s something else going on here, too, I think, surrounding the whole concept of illiquidity. It’s clearly a bad and undesirable thing, in any investment, and it only takes a glance at the market for say Treasury bonds to understand that highly-liquid assets trade at a premium. In theory, then, the converse should be true as well: highly-illiquid assets should trade at a significant discount. And so long-term investors like the Kauffman foundation, who can afford to sit out market fluctuations and don’t need much in the way of immediate liquidity, should be able to buy attractive assets at a low price, and capture that extra yield for themselves.

I’m a long-term investor, too. I have retirement savings I won’t need for a good 30 years; as such, I’m in the market, should such a thing exist, for a long-term, illiquid investment which I can put money into, forget about, and then — if things go according to plan — find waiting for me in 2042 or so worth some vast amount of money which will then fund a lavish retirement. Well, a chap can dream.

The fact is, however, that such investments simply don’t exist: as Mulcahy has found out the hard way, it’s almost impossible to find an illiquid investment which even so much as manages to keep up with the highly-liquid Russell 2000 index. Alternatively, look at the incredibly low yields on syndicated loans, compared to the yields that the same companies pay in the bond market: there’s not really any indication of an illiquidity premium there, despite the fact that loans are much harder to liquidate than bonds are.

And when you do find illiquid investments, such as hedge funds with lock-up periods, or venture capital, or private equity, you invariably find a 2-and-20 fee structure which more than obliterates any premium for illiquidity which ought by rights to be going to the investor rather than the money manager.

Which leaves the one large and illiquid investment which is still made by most American households — housing. If I take out a 30-year mortgage on a house today, then — again, if things go according to plan — I’ll find waiting for me in 2042 a fully paid-off asset which will be able to provide shelter for the rest of my life. It might not have gone up in value, but at least I’ll have dealt with the natural housing short that all living humans need to cover somehow.

If I’m interested in a purely financial investment, however, it’s dangerous and probably a bad idea for individuals or even institutions to look too hard for illiquidity. Because although it pays off over the long term in theory, it’s incredibly hard to find people able of making it do so in practice.

Update: A fantastic comment from Stevensaysyes is worth promoting here:

The illiquidity premium is countered by the fact that certain market participants prefer illiquidity. Financial advisors who bought venture capital over the Russell 2000 were probably happier over the last market cycle, even though the returns were lousy:

-Illiquid investments report quarterly, so clients don’t see the daily lows, and they are less likely to call you with every swing of the Dow

-When clients do see their assets fall, they can’t liquidate everything until the end of the lockup period

-Since illiquid investments don’t have an active market to price them, you can report to clients “optimistic” estimates of their value, and also charge on it

If I were a cynical advisor, I’d put my clients in a portfolio of private equity, venture capital, hedge funds, and private real estate funds regardless of whether I expected them to outperform stocks.

Comments
12 comments so far | RSS Comments RSS

This illustrates an undesirable side effect of the inequitable distribution of wealth – not only when too much capital is held by too few people, so that too many consumers cannot afford to keep the economic engine running at speed, but also there are not enough investments for all that idle capital. So instead of expecting 6-8% returns, those with a lot of capital may only get 2-4%. If they’re lucky.

Moral of the story: don’t starve your customers.

Posted by KenG_CA | Report as abusive
 

Small business is one other area where plenty of people find a large and illiquid investment with potentially large returns. I’m not talking here about angel investing in hopes of finding the next Facebook, but rather starting or buying a business like a restaurant, a bar, a gas station, a dry cleaners, a car wash, a motel, or many others, including franchises.

I’ve never seen aggregate returns for these types of investments, and in many cases a true return on invested capital is difficult to calculate since an owner/operator is contributing both labor and capital to the business. Yes, these types of businesses have high failure rates, but successful ones also generate very high returns on capital. I’d submit that entrepreneurs, and their friends and family, put their capital into these businesses expecting to earn excess returns in exchange for illiquidity.

Posted by realist50 | Report as abusive
 

Felix – do you have a source for your statement that syndicated loans are lower return than bonds?

You can’t just compare current yields, since loans are floating rate and 3-month LIBOR is at 47 bps. You’d have to compare over a long period in the leveraged loan / high yield market, due to both the floating rate question and the fact that loans are almost always senior to bonds, so leveraged loans have better downside recoveries than high-yield. I suppose that one could do this by looking at syndicated loans and high-yield bonds with similar credit ratings over long period of time.

It is widely-know that investment grade revolver commitments are underpriced, since banks (i) use them as a loss-leader to win other business from large companies and (ii) don’t adequately take into account the risk that many large companies are only going to draw heavily on their revolvers when their businesses deteriorate. That said, these unfunded revolver commitments aren’t the loans that are bought by non-bank institutions (or individuals, through loan mutual funds).

Posted by realist50 | Report as abusive
 

Another way of looking at things, Ken, is that real growth only comes through real progress in technology or productivity increases (rather than cost cutting or cheap labour) – in other words, from new ideas.

Since the internet boom of the 1990s there really haven’t been enough (if any) great strides forward, although genetics is perhaps one area for the future. But don’t look at returns in biotech right now as the timescale for research, development, testing and authorisation well exceeds the normal timescale that a typical VC investor wants a return in – and that’s if one of the world’s erstwhile leading technological Nations doesn’t disallow the research on the basis of what was written in a morals manual most recently updated about 1600 years ago.

Posted by FifthDecade | Report as abusive
 

Fifth, real growth can also come through population growth. Europe’s population increased over 30% between 1950 and 1995. Now it is running in reverse.

Technological growth has been perhaps more important, but demographics are a strong headwind to fight at this point.

Posted by TFF | Report as abusive
 

@TFF, Of course, you’re right. As previously discussed in this column at some length, the demographic of the West is aging and moving from productivity to non-productivity; in effect, this magnifies the effect of the flat or falling population, but a big new revolutionary idea would have more effect.

It’s like the difference between Addition and Multiplication – all we’ve been doing for the last decade or so is adding up 2+2 and not noticing that 2×2 could be more powerful because all we have is the idea of using 2 in the formula. What we need is someone to come up with the idea of using a different number so the multiplication will make a difference. But with so much patenting of colours and processes and other legal restrictions on progress (I’m not talking about regulatory issues here) everyone’s so busy navel gazing the big picture remains largely unobserved.

What happened to all the visionaries?

Posted by FifthDecade | Report as abusive
 

The illiquidity premium is countered by the fact that certain market participants prefer illiquidity. Financial advisors who bought venture capital over the Russell 2000 were probably happier over the last market cycle, even though the returns were lousy:

-Illiquid investments report quarterly, so clients don’t see the daily lows, and they are less likely to call you with every swing of the Dow

-When clients do see their assets fall, they can’t liquidate everything until the end of the lockup period

-Since illiquid investments don’t have an active market to price them, you can report to clients “optimistic” estimates of their value, and also charge on it

If I were a cynical advisor, I’d put my clients in a portfolio of private equity, venture capital, hedge funds, and private real estate funds regardless of whether I expected them to outperform stocks.

Posted by Stevensaysyes | Report as abusive
 

Consider too that some illiquid investments, if successful, will by definition become liquid.
(Restricted stock from investing in a startup – if startup does well, most likely goes public – presto turns liquid.)

What about the statistics? How many investments that started illiquid ended up going public and thus made the stock index?

And of course these are often binary results investments – your startup most likely either failed, or went public. So your return is most likely either total loss or something pretty good.

None of that makes for a sensible retirement plan for a person of normal means.

Posted by BryanWillman | Report as abusive
 

FifthDecade, you said:

“real growth only comes through real progress in technology or productivity increases (rather than cost cutting or cheap labour) – in other words, from new ideas.”

Yes, but the progress is relative. It can be offset by having your innovations implemented elsewhere (that’s what happens now). We have separated manufacturing from R&D, so if we come up with a great new invention, much of the growth will occur elsewhere.

And for American businesses, productivity increases mainly come from getting less people to do more work. Which is the opposite of growth.

We have been running trade deficits for decades. These deficits have to be financed either by debt or selling assets. Either way, our standard of living declines. However, it’s not in steps, it’s continuous, and people don’t realize it any more than the lobster stuck in a pot of cool water over a stovetop flame knows he’s dying a slow death. Most people have not equated the lower quality and higher cost of education, the lower quality of food, and the increasing cost of housing and medical care with a lower standard of living, but that’s what has happened. They have been anesthetized by an over abundance od media, gadgets, unhealthy food, and tourist traps, so they don’t see that the water is boiling.

But getting back to technology, we are reducing our investment in real technology, as venture capitalists have been deluded into thinking that ad-supported websites create value, and drive more and more capital to those kinds of companies, rather than ones that actually make things. Businesses in general are not investing a whole lot in the U.S., as evidenced by their record cash hoards. Until they actually invest in evolving their technology, and not trading paper to maximize profits, there will be no economic growth.

Thanks for the opportunity to go off on this tangent.

Posted by KenG_CA | Report as abusive
 

@BryanWillman – I think that you make a good point about timing of liquidity and variability of returns/diversification.

After all, a truly illiquid asset won’t suddenly become liquid in 2042 in Felix’s example. Instead, if it is illiquid, maybe it will be monetizable on favorable terms sometime between 2032 and 2052. Tough for him if he has to take a steep discount trying to sell in 2042. If he has a high degree of certainty that he will get his money in 2042, then what Felix has starts to look a lot like a long-term bond, and a secondary market for liquidity will develop. After all, 30-year treasuries and long-term investment grade corporate bonds are only liquid because someone else will buy them – I can’t make the US government or GE redeem the bond tomorrow – and someone else would probably similarly buy Felix’s hypothetical investment if its 2042 value is predictable.

Felix mentions a house, and income-producing real estate – leased-up commercial space, rented housing, or even timberland – could fit the bill for what he’s seeking. The lack of diversification is a dealbreaker for anyone investing a modest sum, however – do I feel safe putting all my retirement savings in 1 or 2 properties? It’s a different story for big pension funds and endowments, who can build a diversified real estate portfolio even with a small percent of their assets.

Posted by realist50 | Report as abusive
 

The illiquid investments that I can think of provide income, not capital gains. This is actually a great paradigm for retirement, in which you need to provide an income stream for decades and can’t afford to be eating into your capital.

As income-producing investments, their expected return is likely below that of the Russell 2000. But good luck trying to assure yourself of an income stream when investing in a stock index!

Like realist noted, the best illiquid investments offer the owner the opportunity to profitably monetize their skills and labor. Guaranteeing yourself a good-paying job is at least as valuable as guaranteeing yourself a ROIC.

Posted by TFF | Report as abusive
 

Its inevitable that VC investing should generate low returns over time. Its exactly the sort of risk taking that behavioral finance teaches us human beings want to take.

Price dominates growth always.

Posted by topofeatureAM | Report as abusive
 

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