Quiz!
Which are ways to deal with illiquidity?
- Illiquidity is not an issue, as long as the portfolio is diversified and designed for high growth.
- Design a portfolio that can generate income that grows beyond inflation, using the liquid money.
- Keep liquid cash for ongoing expenses.
- Find a few good deals to generate liquid growth.
- Count on income from the illiquid money using conservative assumptions.
- Ignore the illiquid assets when thinking about available money, until they are turned to liquid.
- Hold bonds, to have money aside with low volatility.
7 Rules for Success With Illiquidity
If a big portion of your net worth is illiquid, you may face unique challenges. The challenges apply whether you have $10M, $100M or $1B. People with substantial assets faced these challenges, creating stress and financial risks. Here are a couple of examples of challenges:
- Cash drag: you may keep a large amount in cash or bonds, ready for ongoing expenses, or available for a future investment. This creates a drag on the returns, which can be significant depending on the amount. The problem gets magnified when you depend on the liquid allocation for ongoing expenses – it may not grow enough to cover expenses until a liquidity event.
- Illiquidity risk: in certain situations, you may face a risk of bankruptcy. For example, say your expenses are $1M per year, and you have $1M in liquid investments along with a company worth $500M. You are in the process of selling the company. Large sales typically take time, and buyers back down more frequently than you may expect. If the sale drags for a year, and at the last minute the buyer backs down, you are left with no money to pay the bills which could lead to bankruptcy.
Here are 7 solutions:
- Establish lines of credit (LOCs) or loans that are readily available for temporary cash needs, especially when waiting for an upcoming liquidity event. The first target is LOCs backed by the illiquid assets, when possible, but it could be any asset or business you own. Be very careful of this solution – if used incorrectly or abused (used for long-term spending), it can lead to catastrophes.
- Aim for a low withdrawal rate from your liquid investments. Calculate your typical annual expenses, deduct any conservative income you can get from your illiquid assets under tough circumstances, and divide by your liquid investments. A withdrawal rate of 3%-4% can put you in a strong position depending on the allocation of your liquid investments. At higher rates, your risk level goes up.
- Don’t count on money from the sale of illiquid investments until the money is in the bank. People get nervous with large purchases, and far too many deals fall through.
- When selling a company to a private company, in exchange for shares of the buyer, don’t count on the money until an exit (cash sale or IPO) of the buying company.
- Allocate your liquid money to investments that are designed to provide income that can grow with inflation. While cash & many bonds improve stability, they can lose money to inflation.
- Prepare for difficulty with liquidating your illiquid investments. Allocate your liquid money for high enough growth for as long as you may wait for liquidity.
- Subject to the points above, keep your liquid investments diversified, so you are not dependent on a small collection of companies to help pay for your living expenses.
Illiquidity involves risk, and the solutions above are ideas to help with this risk, to create a successful outcome. They require very careful planning, with serious pitfalls to watch out for. Many liquid investments that grow beyond inflation are volatile and require discipline to stick with through the ups and downs of a cycle. Lines of credit and loans can easily be abused, shifting them from protectors to tools for hurting liquidity.
Quiz Answer:
Which are ways to deal with illiquidity?
- Illiquidity is not an issue, as long as the portfolio is diversified and designed for high growth.
- Design a portfolio that can generate income that grows beyond inflation, using the liquid money. [Correct Answer]
- Keep liquid cash for ongoing expenses.
- Find a few good deals to generate liquid growth.
- Count on income from the illiquid money using conservative assumptions. [Correct Answer]
- Ignore the illiquid assets when thinking about available money, until they are turned to liquid. [Correct Answer]
- Hold bonds, to have money aside with low volatility.
Explanations:
- No matter how fast your illiquid portfolio grows, if you don’t have enough liquid money to cover your expenses, you can go bankrupt, even if you are a billionaire.
- Inflation is a risk that applies even to very wealthy people. Having liquid (accessible) income that grows beyond inflation helps.
- Liquid cash is great for a while, but it loses money to inflation, and doesn’t generate growth for long-lasting income.
- Liquid growth is great. The issue with this answer is the phrase “a few”, implying a concentrated portfolio that may lead to irreversible declines in case of bad luck.
- While illiquid investments may not be accessible easily, some generate income. You can count on the income you expect to get even under tough scenarios to stay conservative.
- Very wealthy people got into trouble counting on illiquid money in the process of selling a large asset, just to see the sale fall through. Don’t count on it, until the money is in the bank.
- Depending on your overall picture, bonds may be helpful and even necessary. But, similar to cash, they are not strong at generating income that grows with inflation and may give diminishing security for longer lasting needs.