Is illiquidity really all that bad?

As a recent Fed report and a recent book have pointed out, forced liquidations can often propagate a death spiral for leveraged investors as more and more assets are dumped to meet margin calls (see related posting).  The Bear Stearns situation is a living case study for this phenomenon.

At the same time, commentators have derided hedge funds for investing in illiquid securities.  By doing so, they say, hedge funds are setting themselves up for just such a situation.  Liquid assets: good, illiquid: bad, they argue.

But is there anything inherently wrong with investing in illiquid securities?  After all, private equity funds have done so for years.  In fact, such investments are considered the key behind the success of university endowments (see related posting).

In his recent book, A Demon of Our Own Design, Richard Bookstaber argues that:

“The very ability to liquidate – clearly a desirable attribute of an investment portfolio – is, ironically, at the root of the liquidity crisis cycle…When the run-of-the-mill corporation cannot meet the terms of its creditors, no attempt is made to throw assets into the marketplace, because there is no ready market for the assets.  The trigger of the liquidity crisis is unique to financial institutions because their assets are liquid and can be marketed to market.  The steel mill that runs into trouble will not face this sort of spiral into oblivion even if its assets are heavily levered because they do not have liquidity.”

Later in the book, he shows how Warren Buffett weathered the underperformance of value investments during the tech bubble because he didn’t face redemptions.  His assets were illiquid and, as a holding company, Berkshire stock had a secondary market.  Famed hedge fund manager Julian Robertson, on the other hand, faced a mountain of redemptions when his fund began to underperform.  This forced him to quickly sell-off assets such as his US Airways holding, only to watch that company get taken out a year later at twice the price.

So it’s not illiquidity per se that causes financial distress, its a liquidity mis-match between two parties in the financial chain that can cause market dislocations.  Indeed, Bookstaber even suggests that idiosyncratic daily demands for liquidity lie at the heart of many quant strategies (particularly statistical arbitrage).

A recent Financial Times article makes a similar point:

“…there is the thorny question of lock-ups. One of the most telling problems highlighted in recent weeks is the danger of hedge funds taking highly leveraged positions based on illiquid assets, such as structured mortgage products, while using short-term funding. Lenders can adapt margin requirements or limit access to funding at short notice. Even equity can evaporate if investors panic and redeem their investments.

“One answer is longer lock-ups, like those enjoyed by private equity groups. They have roughly 10-year investor commitments and long-term debt to match with their illiquid assets (entire companies).

“Although they are also under pressure in today’s turbulent markets they do not face redemptions…”

And an article on Tuesday by MarketWatch (“Escaping the Lock-up“) reminds us why this issue has been pushed to the fore in recent weeks:

“Lock-up provisions are designed to allow fund managers to better manage money rather than be subject to withdrawals and fund-flow hiccups. After all, hedge-fund managers usually need to be nimble enough to properly execute their sophisticated trading techniques. That means they need assets ready and available to trade with, not give back. But what happens when the fund heads south? Or, of even more concern, when an entire sector declines?

“That’s what is on the minds of many investors who own hedge funds linked to subprime mortgages these days. And their options aren’t so great.”

MarketWatch’s Thomas Kostigen echoes Bookstaber when he concludes:

“This all, in a twisted rationale, makes a good case for lock-up periods to remain firm and in place for even longer periods of time.”

Science has always faced the ethical dilemma over whether it should pursue a line of research simply because it can pursue it.  Perhaps we need to ask the same of the financial system: Should an investment be liquid just because it can be marked to market?

It seems that BNP Paribas might answer “no”.  Earlier this week, the French behemoth not only slammed the exit doors on 3 asset-backed securities funds, but also decided to simply cease calculating the NAVs on those funds.  Many will surely say the bank is simply burying its head in the sand.  But its actions acknowledge that part of the problem we face right now is a result of perceived (or more accurately promised) liquidity.  So no NAV, no problem.

Draconian for sure.  But investors in Bookstaber’s hypothetical steel mill would surely see the merits.

Late Breaking Addenum: Looks like Goldman also wishes it hadn’t promised monthly valuations.  According to HFM Week today, the firm has ceased sending out NAVs on its Global Alpha fund.

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5 Comments

  1. Yaser Anwar
    August 9, 2007 at 9:41 pm

    Liquidity is overrated. Like David Swensen once said, “its never there when you need it, anyway”.

    IMO, from what I’ve experienced and read, its not the illiquid instruments that matters during times of crisis; its whether the clients can tolerate the volatility in performance.

    Clearly, the onus is on the manager to not overly focus his/her portfolio in an illiquid market, unless he/she can be nimble enough and have the foresight to see the crunch coming. Looking at past experiences, it is clearly not possible to see the crunch coming. So what should a manager and its investors do? a) Not be overly focused, b) have clients which understand the intricacies of the hedge fund’s operation, so come crisis time they don’t panic and press the sell button; much to the benefit of Citadel in Sowood’s case.

    You gave good examples of Warren Buffett and Julian Robertson, which illustrate that investors in Buffett’s fund were smart and patient enough to weather the storm based on Buffett’s track record and investment style. But what happened to Julian, wasn’t his record superb too? Sure it was. But, during the last few years of operation the Tiger fund had a lot of issues on the operational and personnel level multiplied by the raging bull market of the 99’s. To learn more of the short comings at Tiger, I’d advise reading the biography on Julian Robertson.

    Yaser


  2. David Merkel
    August 11, 2007 at 12:02 am

    The life insurance industry has been through all of this. This is what kills life insurance companies most of the time: illiquid assets, and liquid liabilities. There is a yield premium to illiquidity, which tempts companies to invest there, but when too many assets are illiquid, and liabilities are not, unfavorable credit market performance can lead to the insolvency of firms.


  3. jan sopoci
    August 11, 2007 at 1:30 am

    Regarding the FT article citing hedge funds investing in illiquid assets with short term funding…..hmmmm…sounds a bit too similar to the S&L debacle….borrowing short and lending long in a short term rising rate enviroment…


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