Wall Street Prep

Illiquidity Discount

Understand the Illiquidity Discount Concept

Learn Online Now

Illiquidity Discount

Illiquidity Discount Definition

The illiquidity discount stems from liquidity risk, which is the incurred loss in asset value from the inability to easily liquidate the position.

The illiquidity discount is the discount applied to the valuation of an asset, as compensation for the reduced marketability.

In other words, upon purchasing the investment, there is an immediate risk of value loss where the asset cannot be sold again – i.e. the cost of buyer’s remorse in which it is difficult to reverse the purchase.

The opposite of illiquidity is the concept of liquidity, which is the ability of an asset to be:

  • Sold and Converted into Cash Quickly
  • Sold Without Incurring a Significant Reduction in Value

In short, liquidity measures of how quickly an asset can be sold in the open market without requiring a significant discount

But for an illiquid asset, liquidating the position could be challenging due to:

  • Legal Restrictions from Selling (i.e. Contractual Clauses)
  • Lack of Buyer Demand in the Market

In the second scenario, to exit the position, the seller must often offer steep discounts compared to the purchase price in order to sell the illiquid asset — resulting in greater capital loss.

Determinants of the Illiquidity Discount

The illiquidity discount is a function of the required compensation demanded by the investor in order to invest in an illiquid asset, which takes into consideration the:

  • Opportunity Cost of Potentially Missed Future Opportunities
  • Loss of Optionality in Timing the Exit
  • Expected Holding Period

The more illiquid an asset is, the greater the discount expected by investors for the incremental risk of purchasing an investment with limited flexibility of selling in the future.

For example, early-stage investors (e.g. venture capital) require illiquidity discounts because of the long-term holding period for when their capital contribution is locked up.

The size of the illiquidity discount is contingent on the opportunity cost of tying up the capital to the investment as compared to investing in assets with lower risk (i.e. assets that could be sold even if the valuation were to decline).

  • Higher Potential Returns/Risk → Increased Illiquidity Discount

Illiquidity Discount Impact on Valuation

All else being equal, illiquidity results in a negative impact on the valuation of an asset, which is why investors expect more compensation for the added risk.

Conversely, a liquidity premium can be added to the valuation of an asset that can easily be sold/exited.

In practice, the value of the asset is first calculated ignoring the fact that it is illiquid, and then at the end of the valuation process, a downward adjustment is made (i.e. the illiquidity discount).

The size of the illiquidity discount is largely up for debate, but for most private companies, the discount tends to range between 20-30% of the estimated value as a general rule of thumb.

However, the illiquidity discount is a subjective adjustment for the buyer and a function of the particular company’s financial profile and capitalization.

Thus, depending on the circumstances, the illiquidity discount can be as low as 2% to 5%, or as high as 50%.

Illiquidity and Long-Term Investing

The preference for liquid assets with frequent pricing appeals to short-term investors, such as traders, but one alternative perspective is that the forced long-term holding periods of illiquid assets could potentially result in better returns.

Why? An investor cannot “panic sell” and is basically forced to hold onto the investment regardless of the near-term volatility in price movements.

Patience in terms of timing an exit can often benefit long-term return prospects.

AQR Liquidity Discount

“What if illiquid, very infrequently and inaccurately priced investments made them better investors as essentially it allows them to ignore such investments given low measured volatility and very modest paper drawdowns? “Ignore” in this case equals “stick with through harrowing times when you might sell if you had to face up to the full losses.”

– Cliff Asness, AQR

Source: The Illiquidity Discount?

Illiquidity of Public Stocks vs Private Companies

The statement that publicly-trading stocks (i.e. listed on exchanges) are all liquid whereas privately-held companies are all illiquid is a vast oversimplification.

For instance, let’s compare the liquidity of two different companies:

  • Venture-Backed Company on the Verge of Going Public via IPO
  • Thinly Traded Securities Listed on Over-the-Counter Exchange (i.e. Low Trading Volume, Limited Buyers/Sellers in Market, Large Bid and Sell Spreads)

In this comparison, the public company is more likely to receive a discount to its valuation due to illiquidity.

Other determining factors of the illiquidity discount specific to private companies are:

  • Liquidity of Assets Owned
  • Amount of Cash On-Hand
  • Financial Health (i.e. Profit Margins, Free Cash Flows, Market Position)
  • Potential to “Go Public”
  • Valuation of the Company (i.e. Larger Size → Lower Illiquidity Discount)
  • Conditions in the Public and Credit Markets
  • Economic Outlook

The more venture funding received by a private company and the more diluted the ownership structure is — rather than being a small business with no institutional investors — the more liquid the equity tends to be.

Similar to equity issuances, in which the liquidity is largely dependent on the underlying company’s financial health, the liquidity of debt issuances declines from companies with high credit ratings to those with low credit ratings (and vice versa).

Examples of Liquid and Illiquid Assets

Liquid Assets

Illiquid Assets

  • Stocks with Low Trade Volume
  • Riskier Bonds
  • Real Assets (e.g. Real Estate, Land)
  • Private Companies with Majority Ownership by Founder(s)
Step-by-Step Online Course

Everything You Need To Master Financial Modeling

Enroll in The Premium Package: Learn Financial Statement Modeling, DCF, M&A, LBO and Comps. The same training program used at top investment banks.

Enroll Today
Comments
guest
0 Comments
Inline Feedbacks
View all comments
Learn Financial Modeling Online

Everything you need to master financial and valuation modeling: 3-Statement Modeling, DCF, Comps, M&A and LBO.

Learn More
X

The Wall Street Prep Quicklesson Series

7 Free Financial Modeling Lessons

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.