Illiquid refers to an asset that cannot be quickly converted to cash. Such assets suffer a valuation loss when they are sold in exchange for cash. Bonds, stocks and properties are some examples of an illiquid investment. In other words, it is an uphill task to sell such assets owing to the utterly low trading activity due to a lack of investor interest.
Due to a low trading volume, illiquid assets tend to have a wider bid-ask spread. Bid-ask Spread. The asking price is the lowest price at which a prospective seller will sell the security. The bid price, on the other hand, is the highest price a prospective buyer is willing to pay for a security, and the bid-ask spread is the difference between them.When there is a huge difference between what the seller quotes as the asking price of an illiquid asset and what the potential buyer is willing to pay, it results in a wider bid-ask spread.
This happens because of the absence of readily available markets for such assets. Sometimes, the insufficient market depth and lack of willing buyers lead to significant losses for the owners of the illiquid assets.
Some examples of Illiquid Assets
- Bonds and stocks
- Real estate properties
- Motor vehicles
- Investment in privately held companies
- Shares of small-cap companies
- Various types of long-term debt instruments
- Some of the collectables and art pieces
All these items indeed have a certain intrinsic valueIntrinsic ValueIntrinsic value is defined as the net present value of all future free cash flows to equity (FCFE) generated by a company over the course of its existence. It reflects the true value of the company that underlies the stock, i.e. the amount of money that might be received if the company and all of its assets were sold today., but there is a sizeable amount of money required in their purchase. Moreover, investors often develop cold feet at the mere thought of having their money locked up for a long time in such investments. Together, they often dissuade investors or buyers from making such investments.
Why Invest in Illiquid Assets?
The answer to this question is simple. Sacrificing liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses. is considered as a sound investment strategy by some investors who hope to reap a relatively higher yield in future. Therefore, the possibility of high earnings can compensate for the inability to trade easily.
So, how much extra return can justify such types of investmentsTypes Of InvestmentsStocks, bonds, and cash equivalents are the three main forms of investments. Investment, in general, refers to the purchase of anything for future use with the goal of generating a regular cash flow or increasing the value of something over time so that it can be sold for a higher price than it was purchased for, i.e. capital gains. ?
As there are no thumb rules for the extra return, it purely depends upon the type of investment security and its extent of illiquidity. For instance, small-cap stocks exhibit erratic trading volumes at the exchange, which makes them illiquid. So, the investors try to buy these small-cap stocks at a lower price-to-earningsPrice-to-earningsThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. (PE) multiple and earn a higher return on investment.
While making investments in privately held companies that don’t trade on any exchange, the investors ask for higher risk premiums. Mostly, professionally managed funds with a long investment horizon invest in these companies. As such, the investors have limited freedom to move out of the investment before the funds’ maturity.
Illiquid and Risk
Illiquid securities come with an inherent riskInherent RiskInherent Risk is the probability of a defect in the financial statement due to error, omission or misstatement identified during a financial audit. Such a risk arises because of certain factors which are beyond the internal control of the organization., which leads to liquidity riskLiquidity RiskLiquidity risk refers to 'Cash Crunch' for a temporary or short-term period and such situations are generally detrimental to any business or profit-making organization. Consequently, the business house ends up with negative working capital in most of the cases.. The investor learns of the risk when the market is extremely stressed. In such a scenario, the equilibrium between the number of buyers and sellers goes haphazard. Owners find it difficult to sell off their assets without significant losses. Therefore, the buyers often seize the opportunity by charging heavy liquidity premium to compensate for the limited liquidity.
- Illiquid assets can be a worthy investment for those looking for a long term investment. They give a higher yield in the future compensating for their illiquidity.
- Assets like real estate properties grow in value over time which reduces the impact of inflation.
- Sometimes, the investment in a privately held companyPrivately Held CompanyA privately held company refers to the separate legal entity registered with SEC having a limited number of outstanding share capital and shareowners. gives better returns than a publicly traded companyPublicly Traded CompanyPublicly Traded Companies, also called Publicly Listed Companies, are the Companies which list their shares on the public stock exchange allowing the trading of shares to the common public. It means that anybody can sell or buy these companies’ shares from the open market. as the former comes at a significant bargain.
Aside from the liquidity risk, these assets come with more risks for their investors. The liquidity premiumLiquidity PremiumLiquidity premium refers to the extra compensation desired by the investors for holding assets that are either difficult to be converted into cash or tradable in the open market at a fair price. offered on an illiquid asset is too low. Also, the provisions created against these investments take away a significant portion of their value.
- Illiquid assets suffer from a valuation loss when they are sold in the market in exchange for cash. Some examples of such assets are stock, bonds and properties.
- The investors need to exercise caution as they come with liquidity risk.
- Such assets earn higher returns in future which compensates for the liquidity risk.
This has been a guide to Illiquid and its meaning. Here we discuss why people invest in illiquid assets along with examples, risks, benefits, and limitations. You may learn more about our articles below on accounting –