I’ve argued before that liquidity is the most under-rated quality of an investment. In every crisis fortunes are lost due to illiquidity. Leveraged real estate coupled, businesses, private equity investments all require additional cash liquidity to pull through an economic crisis. In Asia, investors typically hold less than 20% of their total networth in liquid investments, and in many cases less than 10%. In a crisis when prices of investments fall precipitously at the same time, 10-20 per cent of liquidity will never be able to support the cash needs of the balance 80-90 per cent of assets. The end result is that liquidity is wiped out, and in addition some of the illiquid assets need to be sold at deep discounts.

Marketing pitches for illiquid investments are paired with the idea of an ‘illiquidity’ premium, an extra return that investors receive in exchange for locking up their money for multiple years, as well as lower volatility compared to liquid investments like stocks.

The lower volatility is largely an illusion – since illiquid investments re-price their investments infrequently they seem far less volatile than stocks that fluctuate significantly on a daily basis. Both listed equities and private equity investments showed gains during the full year of the COVID pandemic, but in between listed equities suffered a temporary -35% drop in four weeks, while illiquid investments that weren’t forced to mark the value of their investments down showed flat performance. This does not mean that the illiquid investments were less risky, just that the volatility was hidden.

The illiquidity premium can also be disguised. Top decile private equity funds show higher returns than equities, however they also use leverage to amplify their returns, so investors need to dig a little deeper to see whether the excess returns are due to higher risk via more debt, or a genuine illiquidity premium.

While investors should be very conservative in assessing their personal liquidity needs and always err on the side of higher liquidity, this year’s events have generated an interesting situation with a true illiquidity premium. 

The US regional banking crisis earlier this year, where many banks’ balance sheets were simultaneously hit with losses on long maturity government bonds and losses on commercial property loans as interest rates increased sharply, caused many lenders to pull back from markets.  The US crisis almost became a global one after it ensnared Credit Suisse, but swift action by central banks averted further contagion. However shockwaves continue to revibrate through the economy.

Large multi-national companies are naturally finding that refinancing their debt is much more expensive as they issue new bonds. Many of them wisely refinanced into long-term debt when interest rates were zero, and are now flush with cash that is earning more than 5%, putting them in a comfortable cashflow position.

Smaller and medium-sized companies, as well as investors looking to refinance commercial properties, are on the other hand finding it difficult to access loans. They’re unable to issue bonds, and are finding that banks are no longer lending to them. The environment has tilted in favour to the private credit asset class.

Private credit funds are made up of directly negotiated loans on special terms that are not actively traded. Up until last year investors starved for yield were very loose with their requirements, investing into any income-producing structure that promised a decent yield in the zero-interest rate environment. This led to private credit funds accepting large amounts of new investments, causing lenders to compete with each other on deals that led to weak structures with low yields and high risk. 

All this changed as the Federal reserve embarked on its aggressive tightening cycle, with the environment deteriorating even further as four US banks failed. The weakness in commercial real estate continues to put pressure on the banking sector, as many offices are unable to find sufficient tenants to cover their rising mortgage rates.

Private credit has stepped into this vacuum, and is now able to demand higher rates with higher collateral.  Recently private credit funds were able to extract from a well-known leveraged buyout firm an additional $1 billion investment in exchange for providing a $4.8 billion loan with an interest rate of over 12 per cent. The sector is now offering equity-like returns with lower than equity risk, with one caveat, given the weaker macro-economic environment from higher interest rates, the illiquidity of the underlying asset means that manager skill is critical – the size of the equity cushion and the quality of the collateral has to be correctly modeled to avoid default, since the loans are likely to be held to maturity.

With the equity markets’ valuations on the high side after a strong recovery this year, investors who can accept the illiquidity of private credit are now getting paid a premium to do so, and have a potential new asset class to consider within a diversified portfolio.