There is an investment dictum that goes along the lines that: the best investments are generally those that are the most uncomfortable to make.
In this context, referring to illiquidity would probably induce discomfort as the most benign of feelings for most investors.
Since the financial crisis, it seems investors have prized liquidity – or rather the perception that they can get out of an investment if things go wrong.
In similar fashion, assets that have some liquidity constraints can easily be ignored or overlooked. This occasionally presents interesting investment opportunities for those that can do their own research, and are comfortable with the potential risks as well as the returns.
Bad things do happen of course, but good analysis will try and minimise losses. Appreciating this, the expectation should be established that an ‘illiquidity premium’ should form part of the expected return.
It should follow that if you have done sufficient work to feel at ease with holding an investment for the medium to long term, you needn’t be scared of illiquidity in the short term – especially if compensation for illiquidity is perceived to be higher than normal.
To paraphrase Warren Buffett, the root of traditional investing is that investors should be happy holding an investment for 10 years. This is a concept that appears quite contrarian these days when investment horizons are ever shorter.
Accepting illiquidity for an excess premium does not guarantee an easy ride, though. There may well be some mark-to-market volatility, particularly as the infrequency of trading may not be reflective of the underlying value of the asset. Buyers or sellers may be motivated to act without cause for any investment-specific reasons, creating a technical variability around its price.
This phenomenon is hardly unique to illiquid investments and can be seen across large parts of the bond market, where the absence of broker dealers has fostered more of a ‘matched bargain basis’ for some trading, which is particularly evident in larger deal sizes.
But it is possible to access a diverse range of less liquid credit and bond holdings in preference to the traditional corporate bonds, where you are at least being compensated for the illiquidity that prevails.
We have been able to access these more esoteric investments through closed-ended vehicles that appear appropriate for the size or liquidity of the underlying investments. Not only do these products offer attractive starting yields, but they can also provide more limited duration risk from the floating rate nature of their coupons.
The investments that we have been using in this area include secured property debt, secured project finance and infrastructure debt, collateral-backed lending to small to mid-sized enterprises, leveraged loans and other asset-backed securities.
We think these types of holdings present compelling alternatives to the traditional corporate bond market, particularly those that focus on the high-yield space where spread compensation appears very lean.