When an asset or item is liquid it can easily change hands because there is little friction to the trading process and little or no price discovery. Some examples of liquid assets include cash, bit coin, publicly traded stocks, many exchange-traded funds (ETFs), and most municipal and government bonds.
On the other hand, illiquid investments are ones that require some extra effort to exchange, where the fair market price is not easily ascertained, or a combination of both. Examples of illiquid investment assets include penny stocks, rare art and classic cars, capital placed with a hedge fund, and private equity real estate.
Why Liquidity Risk Management Matters?
Declining credit quality across the board but most visibly in the retail sector is exacerbating this stress on liquidity. As a result, some banks are struggling to understand their overall liquidity positions and are finding measurement of liquidity by asset class impossibility. Earlier this year, as a result of the effect of Covid-19, many firms both financial institutions and corporations enhanced cash flow flexibility by attempting to sell some of their stock of high-quality liquid assets, which often formed a major component of their liquidity and capital buffers. Market depth and liquidity almost ceased to exist for a period, and prices experienced severe volatility.
How Do Illiquid Investments Work?
The fact that an investment is illiquid is not necessarily a negative, especially in regard to real estate. Although overall property investment volumes declined last year, capital deployed by private investors was still 9% above the 10-year average, a trend that is projected to continue this year.
Why an Investment is Illiquid?
There are several reasons why an investment is considered to be illiquid:
- Shares in an equity fund or debt securities may be restricted by the private equity firm or by state and federal securities laws.
- Absence of a public market means that the lack of buyers may affect the price of an illiquid investment, compared to publicly traded securities.
- Securities are “passive” by design, such as real estate investments where the private equity firm determines when the project should be sold, and an investor’s capital (along with any potential gain) should be distributed.
Why Do People Use Illiquid Investments?
In order to gain the most benefit from an illiquid investment, the asset must truly be illiquid. The last thing you would want to do is invest in a project where other people could pull their capital on short notice, forcing an asset sale before the time is right.
When you invest in real estate with a private equity firm, you provide the fund manager with long-term capital to see the project through to completion. The asset should be one you are comfortable holding in your portfolio for five years or more, and the real estate private equity firm is one that has a proven track record of success.
3 Pronged Strategies
- First, measure your liquidity early and often.
- Second, stress tests your liquidity through modeling and forecasting different scenarios.
- Finally, craft a strategy to maintain and enhance it.
1. Measuring Your Liquidity
The most common way to measure liquidity is by looking at the ratio of your current assets to current liabilities, or your current ratio. In general, the higher the ratio, the more liquidity you have. The current ratio measures your ability to convert current assets, including cash and cash equivalents, marketable securities, inventory on-hand and accounts receivable to cash. This is measured against obligations you have coming due in the next 12 months. Other metrics, such as the quick ratio, conduct a similar test but exclude inventory, which – depending on your business – can take longer to convert to cash and may be necessary.
One flaw in these ratios is that in a period of economic stress, cash conversion cycles slow down; quick assets become less quick asset. Receivables take longer to collect, and inventory often takes longer to sell. For clients with highly coveted inventory, supply chains can back up.
We advise clients to dissect balance sheet categories and understand how quickly you could convert each asset to cash and at what value. Traditional cash should be easy, and the value should be fairly certain. However, make sure “cash” really means cash. Is the money in an overnight demand deposit at an FDIC-insured bank? A money market fund with daily liquidity? Or could it be a liquid investment with potential to decline in value? The value of marketable securities may have declined; as such, you may prefer not to tap these resources immediately. Setting up a line of credit with your investment advisor can help you avoid liquidating long-term investments at the worst time. Be conservative in valuing current assets; assume late payments on accounts receivable and softening demand/price reductions for inventory. Assume you may need to sell inventory at a discount to raise liquidity.
Private business owners may also factor in their personal balance sheet when measuring liquidity. Maintaining dry powder outside of the business can be a valuable tool to improve liquidity quickly. For businesses with a single owner, the process of adding capital to your business is fairly straightforward, but for partnerships or family businesses with multiple shareholders, the process can be more complicated. In such situations, shareholder loans to the business may be the optimal structure.
2. Liquidity Forecasting
The best-managed businesses will frequently simulate liquidity stress scenarios. This financial modeling exercise involves projecting a slowdown in cash receipts while demands on cash resources increase; for example, what happens if your sales slow 20% over the next three months, receivables take 30 days longer than usual to collect, and you have to change vendor payment terms to cash against documents or prepayment to secure scarce raw materials? Your BBH relationship manager can help you model this risk to better prepare you for the wide range of potential scenarios. In an extreme scenario, what happens if revenue slows to a halt? How much cash do you have to survive four weeks of virtually no revenue? Eight weeks? Suffice it to say that in periods of stress, businesses will often put liquidity over profits in the short term. The ability to perform with your suppliers and customers is a function of liquidity in the short term and will likely provide commercial opportunities that position you for growth when the stress subsides.
2. Managing Debt and Liquidity
What happens to credit facilities when revenue declines, accounts receivable collections slow and inventory accumulates? Liquidity structures governed by asset-based or borrowing base naturally constrict available liquidity. Companies borrowing on cash multiples (for example, debt/EBITDA) may edge closer to breaching covenants due to declining EBITDA. If you expect to violate covenants or have issues with eligible collateral, you should proactively communicate with your lender. Lenders are more likely to respond positively if they know of problems before they occur.
For businesses severely affected by the COVID-19 pandemic, accessing Small Business Administration loans may be critical to survival. Get to the front of the line by submitting your application early, and see BBH’s coverage of the CARES Act here.
What’s more, the crisis may also affect lenders’ liquidity profiles, creating a knock-on effect to their borrowers. Direct lending funds may have rising defaults in their portfolio, restricting access to the bank liquidity they use to fund loans. Traditional banks may be more focused on managing credit issues than lending new money. Funding costs could be rising, especially for lenders with no natural deposit base. Understanding how your lender funds itself is critical. Does it have a natural deposit in the U.S.? Or must it access funding in the wholesale market? Does the bank have any sector concentrations in its loan portfolio that could expose it more to credit losses in this environment?
3. A Strategic Approach – Liquidity over Profits
Liquidity is the lifeblood of business. This truism becomes even more apparent in periods of economic duress. Understanding, measuring and forecasting your liquidity position is crucial to enduring periods of economic contraction and ensuring your business continues to thrive as economic conditions improve. Business owners have many helpful tools. Consider liquidating inventory to raise liquidity, even at the expense of short-term profitability. Develop a communication plan with all of your stakeholders; over communicate with your customers, and be ready for payment delays. Negotiate extended payment terms with your vendors if necessary. In order to enhance your liquidity position, you must have these challenging conversations with all of your stakeholders: employees, customers, vendors, landlords and even lenders. How you manage each stakeholder will directly impact your liquidity position.