What Investors Should Understand About Illiquidity

Illiquidity gets discussed in private investing as though it is automatically either a benefit or a drawback. I don't think either view is particularly useful.

Illiquidity is better understood as a term of the investment agreement. You are giving up access to your capital for some period of time. The real question is whether that trade-off makes sense for your portfolio — and whether you are being appropriately compensated for taking it.

Liquidity has value

If I own a publicly traded stock, I can generally decide tomorrow that I no longer want to own it. I may not like tomorrow's price, but there is normally a market. That flexibility has value.

A private investment may operate very differently. The SEC warns that securities purchased in private placements are generally far less liquid than exchange-traded securities. Investors may face legal or contractual restrictions on transfers, difficulty locating a buyer or circumstances where the investment must be held for a very long period.

When I invest in something illiquid, I am effectively saying: I am comfortable giving up access to this portion of my capital in exchange for the economics of this opportunity.

That should be an intentional decision.

Illiquidity can create opportunity — but the premium is not guaranteed

You will often hear investors talk about an “illiquidity premium.” The underlying idea makes sense. If two otherwise identical investments exist and one prevents the investor from accessing capital for years, investors would generally expect additional compensation for accepting that limitation.

Research has found measurable costs associated with illiquidity. One NBER study of private-equity secondary transactions found that fund interests frequently traded at discounts to reported net asset value, illustrating the economic cost that investors can face when they need liquidity before the natural end of an investment.

But I would be careful about turning that concept into “illiquid investments earn more.” They do not automatically earn more. Illiquidity is a risk investors may expect to be compensated for. Whether they are actually compensated depends on the quality of the investment, the purchase price, the manager, the structure, the underlying asset and ultimately the outcome.

An illiquid bad investment is still a bad investment. Only now it may also be difficult to exit.

Your time horizon matters more than the marketing language

A five-, seven- or ten-year investment may be perfectly reasonable for capital that truly has a ten-year horizon. The exact same investment could be inappropriate for capital an investor may need in eighteen months.

That is why liquidity should be evaluated at the portfolio level, not simply at the investment level. Before making a private investment, I would want to know:

• When might I realistically need this money again?
• How much of my overall net worth is already illiquid?
• Do I have sufficient liquid reserves outside this investment?
• Are distributions expected during the holding period?
• Can the manager extend the investment beyond the original term?
• Are redemptions permitted?
• Is there a secondary market?
• Are transfers restricted?
• What happens if I need liquidity before the investment matures?

Those are financial-planning questions as much as investment questions.

Illiquidity can also change investor behavior

There is an interesting psychological side to private investing. Public markets give us a price every second. That can be helpful. It can also tempt investors to react to every piece of news and every market decline.

Private assets are valued less frequently, so investors do not experience that same daily price movement. But fewer price updates do not necessarily mean less economic risk. The asset can still be losing value even when an app is not showing a red number every afternoon. Private valuations may also require estimates because observable market prices are unavailable.

An investor should never confuse lower observed volatility with lower underlying risk.

Match the capital to the investment

I think the cleanest way to approach illiquidity is to stop asking whether it is good or bad. Ask instead whether it is appropriate.

Some capital needs immediate access. Some capital has a three-year horizon. And some capital genuinely does not need to be touched for ten or fifteen years. Those pools of money should not necessarily be invested the same way.

Illiquidity can be perfectly rational when the investor has enough liquidity elsewhere, understands the commitment and believes the expected economics justify giving up flexibility. It becomes dangerous when an investor chases a return without first considering when they might need their money back.

The best time to think about liquidity is before you need it.