On the blog Texture Capital, a company offering support for issuing and trading in securities, there was an interesting entry devoted to the issue liquidity.
Liquidity risk is one of the most important factors that should be taken into account when making capital investment decision.
It is therefore worth taking a closer look at this issue.
Liquidity subject to research
Capital allocation requires a well-thought-out decision taking into account a whole range of different factors, with expected returns and volatility appearing to be the most important.
The liquidity risk cannot be overlooked either. Liquidity is the basic determinant of the marketability of assets on the market. Its importance and weight is also demonstrated by the fact that many studies have been conducted over the years to verify the relationship between liquidity and asset prices.
They made their summaries Amihud, Mendelson and Pedersen, and the conclusions were concluded in Article "Liquidity & Asset Prices". The authors pointed out that an increase in illiquidity may lead to the required return as long as prices are reduced.
The same authors also specified a certain group of liquidity risk components, which included transaction costs, such as brokerage commissions i taxes, supply and demand pressure related to the absence of a contractor on the market, when the investor is ready to execute the transaction (in which case it may be associated with the need to accept a lower price) and the so-called search friction, referring to a situation where the investor is forced to wait for the relevant counterparty to enter the market, affecting market and financing costs as well as the opportunity cost.
Discount for Lack of Marketbility
The issue of illiquidity was also examined in the context of the valuation of private companies, with the most common lack of liquidity in the case of private investments the secondary market.
Texture Capital draws attention to the phenomenon referred to as Discount for Lack of Marketbility (DLOM).
Great importance is also attributed to restrictions on the resale of securities, with the DLOM estimate being a necessity for correct tax settlement - the value of private investment should be included in the tax on Real estate.
Current estimates and studies show that the discounting of illiquidity is in the range of 10,9-45 percent. As companies record nearly $ 177 billion in revenues from private markets a year, DLOM can cost private investors up to 23 billion a year.