Promissory notes: the problem of illiquidity

The benefits and the trade-off between performance and liquidity

This article will explore the benefits and harms associated with investing in publicly traded and unlisted financial assets. Stocks and bonds are examples of publicly traded assets; The notes and real estate are not listed on the stock market. Both categories can be used successfully, and both can be misused and misunderstood. The analogy of a toolbox applies: the investor must be well-acquired and understand the tools available in their investment toolbox and how to use each tool correctly.

Definition of marketability, liquidity and illiquidity (non-liquidity)

Tradability

Marketability is a measure of the ability to buy and sell an asset. The ability to convert an asset to cash quickly is also known as “marketability.” Poor marketability reduces the value of an asset. Tradability is similar to liquidity, except that liquidity implies that the asset’s value is preserved, while marketability indicates that the security can be easily bought and sold.

Liquidity

Liquidity is the degree to which an asset or security can be bought or sold in the market without affecting the price of the asset. Liquidity is characterized by a high level of business activity. Assets that can be easily bought or sold are liquid assets.

Illiquidity (not liquid)

An illiquid asset cannot be quickly converted to cash. Such investments include limited partnerships, real estate, and unlisted notes.

The Illiquid Assets Challenge

The combination of credit problems, lack of credit information, poor business conditions, and lack of transparency create significant valuation challenges for non-marketable assets. The inability to collect information has become a significant handicap. The absence of liquidity reduces the value of the asset due to the illiquidity discount. All other things being equal, the more illiquid the asset, the less value it has. Measuring this discount and applying it to illiquid asset valuations has always been a challenge.

The benefits of illiquid assets

Now that we’ve learned about the harms and challenges of investing in illiquid assets, let’s explore the positives, the benefits. The benefits are significant and often outweigh the challenges.

• Assets that lack liquidity and marketability offer higher returns

• Assets that lack liquidity and marketability offer less volatility and more stability.

• Assets that lack liquidity and marketability are a better emotional adaptation for some investors.

• Assets lacking liquidity and marketability fit the areas of personal experience and knowledge of some investors; promissory note experts and real estate experts are examples

Valuation of illiquid investments

The experienced judgment of the valuation expert is the key factor. Every valuation method has its flaws. Estimating an appropriate discount for illiquid assets requires judgment. Over the years, court cases have recognized the value of an appraiser’s judgment on the mechanical applications of the general rules.

Some of the factors considered are: financial statements and credit ratings of the borrower, payment history, amount and nature of the collateral, terms and conditions of repayment contained in the documents, loan term, economic perspective, asset control amount, restrictions on transferability and costs associated with collection in the event of default.

It is important to consider all of these factors when selecting the appropriate discount for lack of marketability. While these factors are used as a guide, the appraiser’s judgment remains the key.

Valuing private and illiquid investments is a “trial process.” It requires a robust methodology that:

• established and defensible theoretical framework

• uses methods accepted by investors dealing with similar assets

• uses market information that is reliable and appropriate

Conclution

Illiquid assets can be excellent investments for the right investor, who has bought at the right price and understands himself and the purchased asset.