The Undervalued Power of Illiquidity
He said it as an afterthought as I was leaving his office. But his observation left a deep impression on me.
Earlier in 2023, I met with one of our investors in California. In 2019, he and a few partners started a hedge fund that now manages around $7 billion.
Before that, he and his partners were partners at one of the world’s most successful hedge funds. He made an interesting comment, and I’m paraphrasing and condensing our conversation...
He said, “People don’t appreciate the power of illiquidity!”
He saw my puzzled expression.
“I could raise $50 billion in a heartbeat if we (his fund) could consistently achieve 12% annual returns. But I’d have to be illiquid to do that. On the other hand, you (referring to Wellings Capital) would be disappointed with 12% annual returns. That’s the power of illiquidity.”
I’ve often viewed our funds’ illiquidity as a liability. But here’s the most successful hedge fund manager I know complimenting me on this benefit.
This got me thinking. And reading. And talking with others.
The result is this post. I hope it helps you think through this issue, and I hope you come away enlightened as I have been.
What’s So Bad About Illiquidity?
According to Investopedia, “Liquidity refers to the ease with which an asset, or security, can be converted to ready cash without affecting its market price.”
In talking with many prospective investors, you’d think illiquidity is the worst thing ever. We regularly speak with prospective investors who can’t get over our funds’ projected ten-year hold and associated illiquidity. (We have always attempted and successfully facilitated exits for investors who need to get out, though we don’t guarantee it.)
Most of these folks don’t invest, which is fine with us. We only want investors whose goals and investing values align with ours.
Many of these investors have a valid reason to want liquidity. Some operate with relatively tight reserves and expect important life changes (like medical issues or college tuition). Some believe they will need cash to start a business. Others want liquidity to pivot into other investments when opportunities arise. That all makes sense.
I sense others don’t have a good reason to stay liquid. I’ll chalk their preferences up to familiarity bias. This cognitive bias favors liquid investments like stocks, bonds, and mutual funds since these are most familiar to them.
While I understand this bias, I’m going to challenge this thinking in this post. There must be a reason so many of the world’s wealthiest and most successful investors weight their portfolios toward illiquid investments.
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How the Wealthy Invest
Wealthy investors…savvy investors…institutional investors – share an apparent bias toward illiquid investments and corresponding long hold times. Of course, they invest in liquid investments, too. Consider a few examples.
Let’s examine Berkshire Hathaway’s Warren Buffett and Charlie Munger, arguably the savviest investors of the past century. Berkshire has created its own illiquidity in two ways.
First, they have full ownership of many companies. They cannot trade these shares on a dime like stock market investors, even if they wanted to. And their large stakes in private firms make those holdings illiquid as well. In addition, there would be pricing disruption if they decided to sell any of the large positions of public company shares they own.
Secondly, Buffett and Munger have created effective illiquidity through self-imposed discipline. They plan to hold stocks and companies for a very long time. Buffett said, “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.”
Buffett also said: “Our favorite holding period is forever. We are just the opposite of those who hurry to sell and book profits when companies perform well but who tenaciously hang on to businesses that disappoint. Peter Lynch aptly likens such behavior to cutting the flowers and watering the weeds.”
“The big money is not in the buying or selling, but in the waiting.”
Institutional investors, who have access to capital most only dream of, heavily favor illiquid investments. I don’t have space in this article to go deep, but let’s look at one prolific example.
The Yale Endowment made history when its manager, the late David Swensen, broke away from the pack and made radical investments in alternatives when he joined the endowment in 1985.
University endowments need income (to fund university operations), growth (to stay ahead of inflation), and safety (to ensure the university can thrive for decades to come). Managers traditionally invested heavily in liquid assets like stocks and bonds.
Swensen radically departed with a move toward alternative assets like venture capital, real estate, and even leveraged buyouts. Surprisingly, as of 2021, Yale allocates at least 55% of their endowment portfolio to non-liquid alternatives.
Here is the Yale endowment fund’s target asset allocation for 2021 (the most recent year I could find their published allocations):
The results have been staggering. According to the University, “When Swensen assumed management of the endowment in 1985, it stood at $1.3 billion. During his 36-year term as chief investment officer, his stewardship led to $57.6 billion of investment gains for Yale and more than $21.8 billion of spending to support Yale’s operations.”
Yale is the only Ivy League school that reported a positive return on its endowment holdings in 2022 - no surprise, given their long-term mindset and focus on illiquid assets.
I find it personally satisfying that Yale holds over four times as much real estate as U.S. public equities.
These are helpful examples. But more broadly, let’s look at investment allocations from high-net-worth investors (at least $1 million in liquid assets) vs. ultra-high-net-worth investors (at least $30 million in total assets). This graphic was created by Origin Investments based on data from KKR.
Though we can’t state that every alternative investment is illiquid and long-term, my experience says that most are. Note that UHNW investors hold a significantly higher portion of their assets in alternatives than in stocks, bonds, or cash.
Alternatives include a wide variety of asset types. So, which type do the wealthiest investors favor? Knight Frank’s 2023 version of The Wealth Report reports that ultra-high net worth investors view real estate as their top investment choice (by a high margin) for building wealth.
Illiquidity: A Benefit, Not a Liability
We’ve discussed illiquidity and its often negative reputation among investors. And we’ve considered how many savvy investors embrace illiquidity as a benefit. So now let’s get down to specifics.
What tangible benefits do illiquid and long-term assets provide to investors?
As we review these, please note that I’m not arguing that all these benefits flow directly from illiquidity. Some advantages mentioned below coincide with long-term and illiquid investments, yet these benefits are just as tangible.
The illiquidity premium
I realize this is more often dubbed “the liquidity premium.” But I believe the lesser-used “illiquidity premium” is more accurate.
All things being equal, including profits and wealth creation, most investors would prefer the optionality derived from liquidity. But all things are far from equal, as my hedge fund manager friend pointed out.
Investors forfeit flexibility when investing in illiquid investments. This limits the investor’s ability to quickly alter their strategies and allocate elsewhere. The market effectively requires a premium to compensate investors for this loss of optionality.
This premium often translates to much higher returns over a longer timeframe. How much higher?
“A 2016 time-weight return comparison conducted by JPMorgan between the Burgiss Corporate Finance & Venture Capital Fund and both the MSCI World and S&P 500 indices revealed a one-year illiquidity return premium of 10.4% and 7.2%, respectively. While the averages over extended periods moderated that difference, returns from private markets were routinely 4%-5% higher than the sampled broad market indexes over the previous two decades.”
Source: https://www.iintoo.com/blogs/the-3-virtues-of-illiquidity/
Lower impact from taxes and friction costs
Longer-term investors forego capital gains taxes for years compared to their short-term holding counterparts. The cumulative impact of kicking the tax can down the road can be substantial.
Longer holds also avoid excess friction costs like broker commissions, certain legal and acquisition fees, etc. Buffett has often stated that most investors underestimate the impact of friction costs and taxes.
Reactive selling
Billionaire fund manager and author Howard Marks has made a career from investing against crowd psychology. He wrote an excellent book called Mastering the Market Cycle – Getting the Odds on Your Side. Marks has consistently profited from investing against the herd of reactive buyers and sellers in over half a century in the business.
As humans, we are most likely to buy and sell at precisely the wrong times. Not to sound condescending, but I am convinced that investing in illiquid assets has saved me and our investors from making a myriad of bad impulse decisions. Especially in turbulent times. Speaking of turbulence…
Lower risk in turbulent times
Long-term, illiquid investments are considered riskier by nature. Yet, in practice, illiquid investments often perform far better than liquid assets during turbulent times when investors are desperate for increased liquidity.
A Penn Mutual study showed that theoretically liquid assets like ETFs suffer when many investors attempt to exit simultaneously. The study compared ETF price data (what they traded for) from the 2008 crisis to the net asset value of these funds. This revealed a disparity as high as 11% on high-yield ETFs at the height of the crash.
The report concluded that investors who rode out the liquidity crunch fared far better. Despite our best intentions in good times, humans often sell liquid assets at exactly the wrong time.
Source: https://www.iintoo.com/blogs/the-3-virtues-of-illiquidity/
Asymmetric opportunities
The Efficient Market Hypothesis (EMH) is right most of the time. (Buffett and other great value investors prove there are exceptions, but most of us aren’t that good.)
The EMH demonstrates that given the broad dissemination of information and the massive number of eyeballs studying it, there are no good deals in public markets. Fully liquid public shares are typically priced precisely where they should be.
By their nature, real estate and venture capital trade in assets that are harder to value accurately and harder to buy and sell efficiently. Investors who pursue undervalued mom-and-pop owned value-add opportunities can often acquire assets with significant intrinsic value. This value is typically only mined by investors who forego the instant liquidity of public equities and embrace illiquidity.
These illiquid assets are often ripe for skilled operators who can add value to enhance returns. This opportunity is not as reliably available when investing in public stocks.
Lower timing risk
Assets with shorter projected hold times are likelier to be boxed into a corner to sell at the wrong time. Real estate operators with a short-term view are more likely to finance with shorter-term, bridge, and floating-rate debt. In my experience, short-term operators are more likely to rely on market forces (like a compressing cap rate) to create value.
While not guaranteed a better outcome, operators with a long-term mindset are more likely to finance with longer-term, fixed-rate debt. And they have more flexibility to hold through down parts of a cycle and then choose to sell at a more favorable point in the cycle. And longer-term operators are more likely to ride into, through, and out of an inflationary period, effectively creating a hedge against inflation.
It’s easy to get excited about short-term holds that produce jaw-dropping IRRs in a few years. But let’s be honest: these types of deals often veer into the realm of speculation rather than investing. After speculating quite often in the first decade of my investing career, I committed my focus to true investing for the long run.
Correlation and diversification
Illiquid assets often have a low correlation to the stock market. Yale’s endowment certainly benefits from this feature. Regardless of their underlying operating performance, liquid public equities are often subject to the mood on Wall Street, a CEO scandal, or a war in Europe or the Middle East.
Investing in illiquid assets largely avoids these landmines and provides diversification for those with some of their portfolios in public markets.
Better sponsor/investor alignment
Warren Buffett has often complained about the misalignment between corporate executives and their investors. He observes that public CEOs are often rewarded for taking actions that benefit them at a cost to shareholders. Some of their actions focus more on the next quarterly earnings call than the long-term benefit of the real business owners: their investors.
Many private real estate and other illiquid opportunities we see focus on rewarding investors first. Typical waterfall structures pay investors a preferred return before sponsors participate in the profits. This structure is transparent and legally established in advance, not alterable in a boardroom vote. In addition, good private real estate sponsors invest their own money in the deal on the same terms as other investors, which creates further alignment.
While this doesn’t guarantee better management or a better outcome, I would certainly rather invest in this structure than in a public company that rewards its CEO with eight-figure bonuses for creating short-term results.
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Concluding Thoughts
Everyone needs liquidity—a cautious emergency fund. No sane investor would have a portfolio of 100% illiquid assets.
Everyone must determine their own “liquidity comfort level.” The amount of their investments they can quickly convert to cash.
We believe that investors who want to maximize their returns and wealth creation capacity should first achieve this comfort level and then consider illiquid, longer-term assets for investments above this level.
The data is clear. The practice of large investors serves as a guide. And we believe the benefits far outweigh the downsides.
For many savvy investors, illiquidity is genuinely a feature, not a liability.
DISCLAIMER: Investors should consider the investment objectives, risks, charges, and expenses before investing. For a prospectus or a summary prospectus with this and other information about any Wellings Capital fund, please call us at 800-844-2188 or contact us at invest@wellingscapital.com. Read the prospectus carefully before investing.
This article is for educational purposes only and is not to be relied upon as the basis for entering into any transaction or advisory relationship or making any investment decision A more detailed explanation of the various assumptions and risks associated with hypothetical information in this email is set forth in the Private Placement Memorandum ("PPM") for Wellings Real Estate Income Fund ("WREIF"). Please read the PPM before making any investment decisions. All terms of this section are subject to the terms of the PPM. All investing involves the risk of loss, including a loss of principal. We do not provide tax, accounting, or legal advice, and all investors are advised to consult with their tax, accounting, or legal advisers before investing. Information and any opinions contained in this article have been obtained from sources that we consider reliable, but we do not represent that such information and opinions are accurate or complete, and thus should not be relied upon as such.
