The Illiquidity Discount – Costing Issuers Tens of Billions of Dollars per Year

Investors take many factors into consideration when deciding how to allocate capital. Expected returns and volatility are the two most well understood factors and form the basis of modern portfolio theory. But another important factor that can have a significant impact on performance is liquidity risk. Stated simply, liquidity is a measure of how easy it is to buy or sell an asset in the market, and liquidity risk is the risk that a given financial asset cannot be traded quickly enough in the market. 

There are numerous academic studies that have sought to study the relationship between liquidity and asset prices. Amihud, Mendelson and Pedersen summarize these studies in their paper Liquidity & Asset Prices[1]. In the paper they note that:

“An increase in illiquidity implies that the required return increases…” “which is achieved by lowering current prices”

In addition, they identify a number of different components of liquidity risk including: Transaction costs -for example: brokerage commissions, spreads and taxes; Supply and demand pressure - this arises if a counterparty is not present in the market when an investor wishes to trade. In order to attract interest, the investor may have to accept an inferior price; Search Friction - this occurs when a trader must wait until a suitable counterparty enters the market increasing market risk, financing costs and opportunity cost.

The topic of an illiquidity discount has also been extensively researched in the context of private company valuation. In this field it is referred to as the Discount for Lack of Marketability reflecting the fact that for private investments there is often no liquid secondary market with restrictions of resale of securities identified as a key factor. Assessing the Illiquidity Discount here is essential for taxation purposes as a value for private investments needs to be accounted for in estate tax, gift tax and other taxation purposes.  Indeed, the IRS has published on their website a one hundred- and sixteen-page document[2] on measuring the discount for lack of marketability and includes a summary of some of the studies shown below[3]:

As we can see, the empirical studies suggest an illiquidity discount in the range of 13% - 45%. With operating companies raising about $177bn[4] in private markets per year according to the SEC, the illiquidity discount is costing private issuers at least $23bn per year.

“And if liquidity costs and risks affect the required return by investors, they affect corporations’ cost of capital and, hence, the allocation of the economy’s real resources.” - Amihud, Mendelson and Pedersen[1]

Texture Capital is developing growth strategies to improve the functioning of primary and secondary markets for private securities. Utilizing blockchain technology and smart contracts Texture can improve transparency, reduce frictions and increase liquidity in private securities, thereby reducing the illiquidity discount borne by participating issuers.

We look forward to discussing our strategy in more detail in future blogs. Please sign up here to receive news and updates from Texture Capital.

[1] http://pages.stern.nyu.edu/~lpederse/papers/LiquidityAssetPricing.pdf

[2] https://www.irs.gov/pub/irs-utl/dlom.pdf

[3] http://www.willamette.com/insights_journal/16/winter_2016_5.pdf

[4] https://www.sec.gov/files/DERA%20white%20paper_Regulation%20D_082018.pdf