Corporate America now knows the menace of liquidity risks all too well, thanks to the financial crisis that gripped Wall Street in 2008. Actually evaluating and managing those risks, however, is still mostly mystery.
Lehman Brothers, AIG, and Merrill Lynch are only a few of the firms that collapsed into bankruptcy, receivership, or forced merger during the crisis, after assets on their balance sheets suddenly froze into dreaded “illiquid” status. Unable to value the assets (let alone sell them), the firms quickly met their demise.
No wonder, then, that boards and investors alike fear illiquidity more than ever, and want more transparency into their investment risks and the methods used to value them. The problem? “By their very nature, illiquid investments often offer investors poor price transparency,” says Justin Burchett, a valuation specialist for Grant Thornton. “The main risk to fund managers and investors of holding an illiquid asset is the inability to transact at a known price within a short timeframe.”
Valuation experts stress that liquidity risk is not just restricted to illiquid assets. “One lesson learned from the recent financial crisis is that assets that were thought to be liquid may become illiquid during times of severe financial distress,” Steven Jameson, chief internal audit and risk officer of Community Trust Bancorp, tells Compliance Week. Examples include many securitized investments, collateralized debt obligations, and cash management accounts. Buyers might bail out of a market, or counter-parties fail to honor prior commitments—either way, companies are still left with the problem.
Illiquid assets are difficult to value and sell for a host of reasons. The markets for them often have a limited number of participants, Burchett says, so entering into any transaction can pose significant search costs to match the right buyer with the right seller. What’s more, information about the asset itself might be private, or one party might know much more about the underlying value than the other (private equity or venture capital investments, for example).
All that leads to the fundamental problem: lack of reliable pricing information. And without observable transaction prices, Burchett says, companies are hard-pressed to hedge the liquidity risk of the asset effectively. He recommends that investors and companies instead focus on mitigating liquidity risk, rather than hedging against it.
“We recommend increased up-front due diligence on investment strategy,” he says. That includes gauging how much experience management has with liquidity shocks, and assessing any market information advantages they may have.
Gunderson
Cory Gunderson, a managing director with consulting firm Protiviti, says businesses buying financial assets (be they banks, investment funds, companies socking away spare cash, or anyone else) should link their purchasing strategies to their risk appetite. For example, a money management fund should not be buying highly structured securities when its main investment purpose is to provide overall liquidity to the enterprise, Gunderson says.
And once the purchasing strategy is linked to the company’s risk appetite, the company must keep monitoring those assets to understand how the investments are shifting in risk profile, he says. “Far too many investors relied solely on outside parties’ viewpoints such as investment managers and rating agencies, rather than using those parties as good data points to be added to their own analysis and judgment,” says Gunderson.
New Disclosure Rules
To that goal of greater transparency, the Financial Accounting Standards Board has published new rules requiring companies to disclose how they determine the fair value of assets and liability. As Compliance Week previously reported, companies must now group all assets and liabilities into three categories: Level 1, with clear, observable market prices; Level 2, a mixture of market prices and modeled estimates; and Level 3, where prices are derived entirely from financial models. Companies must also disclose when they move an item from one category into another.
“The main risk to fund managers and investors of holding a liquid asset is the inability to transact at a known price within a short timeframe.”
—Justin Burchett,
Valuation Specialist,
Grant Thornton
For instruments measured at Level 3, companies are required to present separate information (not final net numbers) on purchases, sales, issuances, and settlements. The rule takes effect for the 2010 reporting year for calendar-year companies.
Marshall
Randy Marshall, a managing director with risk consulting firm Protiviti, says he is seeing more investors interested in the details of those Level-3 assessments: how they’re designed, the assumptions they make, the mathematical algorithms behind them, and back-testing to see whether modeled prices matched up to sales that actually happened.
Disclosures like that may help clarify liquidity risk to investors, Burchett says. Other useful metrics might be the estimated time to sell or unwind an investment, or the liquidation sale value.
Third-party reviews of these processes can help ease investor uncertainties. One wise idea is to include a third-party review of fair-value estimates to demonstrate to investors and auditors that the company is exercising appropriate judgment, says David Larsen, a managing director in Duff & Phelps portfolio valuation practice. “Recent guidance … highlights the benefit to investors when qualified third parties are part of the valuation process.”
Internal auditors can provide those independent reviews through spreadsheet testing and model validation, Jameson says. “Reviewing the governance processes that are in place can help ensure that companies are considering risks appropriately and adequately disclosing risk-management activities to investors.”
In late 2009, FASB also issued guidance on how to determine the fair value of an interest in an alternative investment fund (hedge funds, private equity funds, real estate trusts, and the like). Hedge funds need to develop methods to measure the value of liquid investments, looking at such things as tolerance of volatility, the patience to wait for long-term returns, and flexibility to respond to changing market conditions.
Marshall welcomes the new disclosure rules. “Investors’ ability to understand the relative performance of an illiquid investment in varying economic and market conditions will improve transparency, and enable an investor to make a better assessment of the relative value established by the investment manager,” he says.
Illiquid investments made by hedge and private equity funds must also be valued at fair value. “It’s clear that alternative-asset managers need to provide a rigorous, timely, estimate of fair value for underlying investments,” Larsen says.
There is, of course, an upside to betting on assets that carry some liquidity risk: They can make lots of money. High-yield junk bonds, emerging market debt, and similar risky classes of assets often do well after a market shock—and sure enough, many of those assets have performed nicely since the stock market bottomed out one year ago.
“As market conditions have changed dramatically, many investors have benefitted significantly by entering into or holding illiquid assets over the past year,” agreed Marshall.
But Burchett warns that investors incur costs where they demand higher returns for these investments. “Although there is a ‘premium’ for illiquid assets, the real cost can be significant.”
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