Understanding Liquidity in the Private Markets

Hosted by Bob Simpson, today we shift the focus to answering the question "What is Liquidity?".

In this episode Bob explores the complexities of liquidity in both private and public investment markets. He is a veteran of the financial industry, discusses the evolution from transaction-based to fee-based business structures and the gradual integration of private mandates into investment portfolios. 

He emphasizes the importance of understanding liquidity and its implications for various investment strategies, including private debt and equity solutions.

Simpson provides insights into the challenges of managing liquidity in private investments and the need for aligning investors' time horizons with investment strategies. 

He also compares the performance of private investments with traditional options like stocks and bonds, highlighting the importance of evaluating risk and returns. 

The episode concludes with Simpson underscoring the significance of patience and informed decision-making in navigating the financial landscape.

Points of Interest:
0:00 - Intro
1:00 - A deep dive into liquidity.
2:49 - Investors are faced with implications of reduced liquidity due to increase popularity.
4:30 - Your investment advisor should always have your best interest in mind! 
6:44 - Private managers work hard to give investors what they want.
7:54 - It's important to understand where your investment money is going.
9:08 - Plan your investment according to your financial goals.
11:11 - Are your stock funds accessible when you need them?
14:37 -  When time horizon's and investment processes align, it protects long-term interest.
16:05 - Review your current investments and seek comparable advantageous opportunities.
17:09 - Does providing investors with greater liquidity actually serve their best interests?
18:22 - Your financial journey begins when you understand your relationship to liquidity.

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Transcript

0:14

Greetings to our audience on my private network, the window to the world of private market investments. I'm Bob Simpson here to accompany you on this voyage. Today's discussion will focus on the intricate landscape of liquidity and its influence on both private and public investment realms. Before I begin, I'd like to provide a big shout out to James Biron and Casa. The Canadian Association of Alternative Strategies and Assets, who gave me the opportunity to be a presenter at the Wealth Managers Forum 2024 in early March to discuss In today's episode, I'm taking a solo deep dive into a topic that's a constant buzzword in the realm of private market investments. Liquidity. We're stepping away from our usual manager interviews to tackle the nuances of liquidity. Particularly how it differs when you're invested in private debt or equity solutions compared to public market instruments such as stocks. Think giants like Microsoft or Royal Bank, mutual funds, or various types of bonds. Now, if you've read my bio, you'll know that I'm a 40 year veteran of the financial services industry, but more importantly, I've seen the industry from a variety of different vantage points. I've been successful as a financial advisor. I've been a branch manager, a portfolio manager for a publicly traded insurance company. I've been fixed income strategist for Canada's largest independent investment dealer and advisor to financial advisors over the past 25 years. Now I work with a wealth management firm, have developed a website to educate investors about investing in private markets, and do this podcast. You know, it may sound like a lot of change, but spread over 40 years, it's pretty stable. Throughout my tenure, I've witnessed a myriad of experiences, some uplifting and honestly, some rather disheartening. Yet what remains constant is the sluggish pace of change. A notable transformation within the financial advisory landscape is the progression from transition based to fee based business structures. This evolution marks a pivotal shift from the traditional transactional approach where advisors earnings were contingent on portfolio activity to a fee based framework that fosters a greater alignment of interests between advisors and their clientele. Implementing this change was undeniably beneficial. Yet it required over two decades for the industry to embrace it. In today's episode, we're delving into a trend that's still in its infancy for many advisors and clients, the integration of private mandates within investment portfolios. This practice isn't new to large pension funds, some of which now hold a larger share in private investments than public ones. And this is kind of interesting. Their shift was driven by the struggle to meet their objectives with bonds yielding near historic lows and the volatility of equities exceeding their comfort level. Now, just listen to that again if you want to, but does that sound like a familiar scenario to you? As private investments become more commonplace, both advisors and investors are grappling with the implications Of reduced liquidity in our deep dive today. We'll explore the nuances of liquidity in private investments In a business where advisors get paid each deal they make they want to keep their clients money Easy to move around that way they can make more deals and earn more It sounds easy, but changing how things are done takes a long time and the old ways of doing things can stick around Just think about real estate agents They like people who move and buy a new house every few years because that's how they make money. They don't really like people who stay in one house for a long time. Like someone who's lived in the same house for 40 years and wants to stay there even longer because they can't earn anything from them very often. In a world where you pay for advice, The person giving you advice should always do what's best for you. Imagine if you had bought Microsoft stock and just kept it for 15 years, you would have made a profit of over 17 percent per year. Well, not every year, but 17 percent annualized. If you just buy and keep good stocks, that's often the best way to make money. Like in Canada, there is a company called Boyd Group that fixes up old car repair shops, and their value has gone up by 26 percent per year over the last 20 years. Over that same timeframe, Royal Bank has gone up 11. 5 percent per year annualized. Sure, if you didn't buy Microsoft in 2022, you would have avoided losing 28 percent of its value that year. And if you didn't buy or hold Boyd, you wouldn't have seen a 9 percent drop. But who's to say that we can be so precise with our investments? If you had sold Microsoft because you thought that it costs too much, but then it went up 20%, honestly, would you be able to admit that you were wrong and buy it back? Really good stocks often go up when people are worried and it might seem like a good idea to sell when things look bad. But like today, when I'm making this recording, the sun is shining. Good times come around just around the corner. Why do people who give investment advice often say to keep your money where you can easily use it? I'm, not trying to criticize anybody just looking at the reasons Could you have guessed that companies like microsoft boyd or royal bank would have done as well as they've done? You might find plans written by these companies from years ago when they plan to achieve these results. That's what great companies do. They plan to grow their business. Of course, lots of things change during those plans, but a good management team writes down their goals and are ready to make changes if they need to. They keep their eyes on their goals and they check the scoreboard when the game is done. So let's talk about investing in businesses that aren't on the stock market. The people who are really good at managing these investments have a game plan and a way of doing things. They've usually been handling money for years. They probably learned the ropes by staying up late when they were newbies, digging through piles of paperwork to impress their bosses. Eventually, they became the bosses themselves, got fed up with the red tape, and decided to set up their own investment companies. They work to give investors what they want, or what they think they want, while still sticking to their investment strategies. They aim to keep the money flowing freely and make sure that it doesn't get stuck or trapped In a particular investment, they invest the way investors tell their clients to invest, like planning to keep the money in an investment for five to 10 years. But it's tricky because investors might want their money back at any time. If you're putting your money into investments to get regular income, it's crucial to understand what you're really investing in. Like if you're thinking about investing in a mortgage investment corporation, you should know how they work and what the risks are. For instance, this is an investment that has a lot of mortgages with short term maturities and the people who borrowed the money Have put a lot of their own cash into their homes So even if the housing market hits a rough patch You're less likely to lose your money or take another investment that loans against receivables The turnover is quite quick, but the manager imposes more restrictive redemption terms Because they don't really want to attract the type of investors who are here today and gone tomorrow But don't get hung up on the jargon. The main thing to remember is when you decide to invest in something you should really believe in it and plan to stick in it for at least five years. Now, if you're into day trading, that's a whole different ballgame and none of this applies. This leads nicely into a chat about financial planning. When you plan your finances, you figure out what you want your money to do for you in the future. That's like setting up targets for your cash. When you'll need it, how much you're going to need. So you want to quit working in 15 years with 4 million to live comfortably in retirement, but you also have cash needs. that might come up sooner, like paying your kid's university, getting a new car, maybe a vacation home, or taking a fancy trip. In other words, you need to organize your money into different buckets based on when you'll need to use it. We call these long term, midterm, and short term buckets. Investing wisely means picking great assets for each bucket that you can cash in when you need the money. For the long term bucket, tying up your money in something like a townhouse project in Hamilton for 10 years, a five year condo build in Toronto, or buying farmland in southwestern Ontario might make sense. For your midterm goals, you could invest in a fund that builds houses in Texas where lots of people are moving, or team up with a company that lends money privately. And for your short term bucket, you might consider the Mortgage Investment Corporation that I referred to earlier, where you can get your money in just two days, with better interest rates than you'd get in super safe investments like GICs. Your advisor should really act as a guide, helping you map out financial targets and how soon you'll want to hit them. He should be like a coach who assists in picking the right financial tools that will get you to your goals on schedule. They're there to help you invest in a way that maximizes your chances of success. Well, keeping your risks as low as they can. All right, I'm going to speak my mind here. You know that moment when you start working with a financial advisor and she asks you how much risk you're comfortable with. She might even have you fill out a questionnaire to help figure it out. But honestly, you really have no idea. Until you've actually gone through it. Sure. There are some tests that like the ones that we use to gauge psychological reaction to risk, but it's not until the market takes a deep dive that you really understand how risk feels like when the technology stocks crash in the early two thousands or the financial crisis in 2008 or big drops when the pandemic hit. And look, I get it. The S& P has given us a return of over 7 percent a year since the end of 1999, and results since 2012 have been spectacular. But many would say they didn't expect a bumpy ride for a 7 percent return over a 22 or 23 year period. The tricky part Is that when you need to pull out the money, it could be the worst possible time. Like let's say you needed money in February of 2009 or March of 2020. If you're able to just hold on because you didn't really need the money until the market bounced back, you'd be fine. But what if you needed your money at exactly the worst times? Even though stocks can be sold quickly, the real question is whether they are truly accessible when you need the money, especially if their value is dropped by 40%. Would you be able to withdraw the amount that you need without a loss at that time? Advisors often recommend a mix of stocks and bonds to manage risk. However, during the financial crisis in 2008, 2009, the strategy was less effective. The TSX index fell by 39 percent from December, 2007 to March of 2009. Well, bonds only provided a return of 6%. If you had half your investment in stocks and half in bonds, you would have still seen a loss of 16. 5 percent over that period. Generally stocks and bonds move in the opposite directions, but from March to September, 2022, they both decreased with the TSX losing 7. 5 percent and bonds losing 9 percent even after interest and after fees, the numbers on your statement would have looked even worse. Now don't misunderstand me. I praise certain stocks like Microsoft, Boyd and Royal Bank. However, you can't simply ask your advisor to create a portfolio for you that will surely give you a 20 percent annual return by the specific date. Let's say March 14, 2030 stock market's unpredictable. You might expect a return of six to 8 percent over the next decade, but as your long term investment horizon gets closer, you probably should consider moving money into something more stable and secure Especially If it's income that you're going to be needing rather than growth. This is particularly true. If you need a lump sum at a certain time, unlike retirement savings, which might be withdrawn gradually, allowing you to maintain a growth focused investment strategy over a longer period, private market investments are not as liquid as public equities. Largely due to the nature and structure of these investments. Liquidity terms are aligned with the underlying business strategy and the collective benefit for investors. For instance, real estate improvements in multifamily properties requires a multi year horizon for renovations, which can extend if the market softens. Music royalties, student housing investments offer. Periodic redemptions, but discourage early withdrawal with fees. Private lending strategies that match investor lock up periods with loan durations ensure stability, but may introduce gates to manage significant redemptions. Conversely, a mortgage manager with short term loans can afford more liquidity. Generally, private market managers expect investors to commit to the investment term suitable for the strategy. It may be a four to five year lockup for property investments or no liquidity with high return targets for development projects. They seek investors whose time horizons align with their investment process to avoid disruption in the management and protect long term investor interest. As an investor, it is essential to evaluate the returns of private lending against risk free options like GICs. Guaranteed investment certificates, ensuring that the premium over GICs justifies the risk and tax implications. For private equity investors, benchmarking returns against established indices like the S& P 500 or the TSX or comparing them with potential earning from other investments is crucial. Ultimately, the decision hinges on whether, after considering factors like risk and liquidity, the returns from private investments are more advantageous compared to other available options. At PD& E, we're committed to presenting all necessary details about various concepts, allowing you to conduct comparisons yourself or have us assist you in the process. So lastly, I'd like to highlight the costs associated with short term investment strategies. A compelling report entitled The Influence of Investor Behavior published by RBC Investment Management and quoting research from Delbar in May of 2018 offers valuable insights. Despite the advised holding periods, the report found that over a 20 year span, mutual fund investors held equity and fixed income funds for an average of only 3. 6 and three years respectively. Well, balanced fund investors stayed aboard for about 4. 6 years. This behavior resulted in average annual underperformance. Yes, that's underperformance of 4. 2 percent for the balanced fund investors compared to those who adhered to their investment strategies over the long term. This raises the important question. Does providing investors with greater liquidity actually serve their best interests? As we wrap up today's episode, remember the path to financial wisdom is not always straight. It's a journey that begins with understanding many factors and your relationship with liquidity. Investing is not about the thrill of potential gains. It's a deliberate and calculated approach to securing your financial future. It's about knowing when to hold on, when to let go, and having the clarity to understand the difference. Thank you for tuning into My Private Network. I'm Bob Simpson reminding you that in the world of investments, Investing Sometimes the most valuable currency is patience. Join us next time as we explore another facet of the financial universe or open a door to one of our investment professionals in my private network. Until next time, have a great day.