Reading a recent whitepaper on inflation from OneRiver Asset Management (a worthy read if you have the time), I came across the following quote about psychological drivers behind illiquidity:

“…Amartya Sen’s work on famines made a big impression on me. When I eventually became an investor, I would often think about his work as various manias and panic unfolded. Grossly oversimplifying…he found that famine wasn’t caused by actual scarcity of food but the fear of scarcity which led to hoarding behavior and the hoarding behavior ultimately created the supply disruptions that caused the famine. The way markets behave in a leveraged unwind has similarities, where an isolated liquidity problem or leveraged stop out can spread because fear of a generalized liquidity problem causes people to trade more conservatively and hoard liquidity which then creates its own illiquidity.”

Having just reviewed (and rejected) a crappy public BDC with a mismatched balance sheet (over-levered non-permanent debt used to purchase illiquid “private credit” investments), I thought it worthwhile to revisit the topic of liquidity/illiquidity. Conveniently, in March 2015, Howard Marks wrote an entire memo dedicated to the topic of liquidity. Below is Part 1 of highlights and excerpts:

Defining Liquidity

“…people think of liquidity as the quality of something being readily saleable or marketable…whether it’s registered, publicly listed and legal for sale to the public…the more important definition of liquidity is… ‘The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price’…the key criterion isn’t ‘can you sell it?’ It’s ‘can you sell it at a price equal or close to the last price?’ Most liquid assets are registered and/or listed…to be truly liquid…one has to be able to move them promptly and without the imposition of a material discount.”

“Investment managers are often asked how long it would take to liquidate a given portfolio. The answer usually takes the form of…‘We could sell off x% of the portfolio in a day, y% in a week, and z% in a month, etc.’ But that’s a terribly simplistic answer. It doesn’t say anything about how the price received would compare with the last trade or the price at which the assets were carried on the previous valuation date. Or about how changing market conditions might make the answer different a month from now.”

Liquidity of asset/security is not defined by the registration process or public/private status, or how long it would take to liquidate based on historical conditions. It’s defined by how quickly you can sell it at a future point in time without incurring a (significant) price discount.

Ephemeral Nature of Liquidity

“…many of the important things in investing are counter-intuitive. Liquidity is one of them…It’s often a mistake to say a particular asset is either liquid or illiquid…by its nature. Liquidity is ephemeral: it can come and go. An asset’s liquidity can increase or decrease with what’s going on in the market. One day it can be easy to sell, and the next day hard. Or one day it can be easy to sell but hard to buy, and the next day easy to buy but hard to sell.

…liquidity of an asset often depends on which way you want to go…and which way everyone else wants to go. If you want to sell when everyone else wants to buy, you’re likely to find your position is highly liquid: you can sell it quickly, and at a price equal to or above the last transaction. But if you want to sell when everyone else wants to sell, you may find your position is totally illiquid: selling may take a long time, or require accepting a big discount, or both. If that’s the case…then the asset can’t be described as being either liquid or illiquid. It’s entirely situational…Further, the liquidity of an asset is very much a function of the quantity involved. At a given time, a stock may be liquid if you want to sell a thousand shares but highly illiquid if you want to sell a million. If so, it can’t be said categorically that the stock is either liquid or illiquid.”

“Specific investor actions can have a dramatic impact in illiquid markets. For example, the price of an illiquid asset can rise simply because one buyer is buying, in which case selling the asset becomes very easy. When that buyer stops buying, however, the market can quickly reset to much lower levels in terms of both price and the liquidity enjoyed by sellers (and it can overshoot in the other direction if the buyer decides to sell what he’s bought).”

“In assessing an asset’s liquidity, one should think about the other people who hold it…Are they all the same type of investor…Do many of them own it in funds whose investors have the right to make quick withdrawals? And…are they highly levered and subject to potential margin calls? The more ownership is concentrated in the hands of investors who could become motivated to sell en masse, the faster liquidity can disappear.”

“For the last few years I’ve been expressing my view that (a) investors – driven by central bank-mandated interest rates near zero – have been moving into riskier investments in pursuit of higher returns and (b) in taking that step they’ve often ignored the need for caution or been ignorant as to how to achieve it. I believe that as an important part of this behavior, those investors have extrapolated the high level of liquidity they’ve witnessed in the last five years, failing to understand its transitory nature.”

“Liquidity can be transient and paradoxical. It’s plentiful when you don’t care about it and scarce when you need it most. Given the way it waxes and wanes, it’s dangerous to assume the liquidity that’s available in good times will be there when the tide goes out.

What can an investor do about this unreliability? The best preparation for bouts of illiquidity is:

• buying assets, hopefully at prices below durable intrinsic values, that can be held for a long time – in the case of debt, to its maturity – even if prices fall or price discovery ceases to take place, and
• making sure that investment vehicle structures, leverage arrangements (if any), manager/client relationships and performance expectations will permit a long-term approach to investing.”

Liquidity is not a permanent characteristic of any investment. It is influenced by the sentiment and actions of other market participants (supply and demand) and thus can change over time.

The Sizing of Liquidity

“…the best way to deal with the issue of liquidity is to think of the portfolio in terms of layers ranging from highly liquid to totally illiquid. The appropriate size for each layer at a given point in time is a function of each investor’s specific situation, as well as the position of the market in its cycle…In sizing those layers, it’s clear that no investor should shoulder more illiquidity than its realities permit…Portfolios may be required to (a) meet their owners’ needs for current cash with which to operate, (b) fund capital drawdowns at a time when lock-up funds aren’t making distributions, or (c) enable the owners to avoid having to sell assets at depressed prices. Thus portfolio liquidity should be set so these needs can be met in bad times…These decisions require judgment.”

“…liquidity…is multi-faceted and complex, not simple. There are a lot of considerations to be taken into account, and certainly no simple formula for doing so. Like everything else in investing, there’s no surefire way to manage the issue of liquidity in the absence of superior insight.”