Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

The Ills of Illiquidity – Potential Pitfalls of Investing in Non-Marketable and Illiquid Securities

As investors scour the financial landscape in the search for lucrative investment options, it is easy to be tempted by the lure of the potentially high returns often touted by issuers of non-marketable securities. These are financial instruments which may generally be exchanged for cash only by dealing directly with the issuer. Some issuers might require investors to lock in their capital for months or even years, while others limit the amount of shares which can be sold within a particular period of time. The result is that an investor may be required to hold the security despite the availability of other, possibly more attractive investment opportunities which may arise in the future.

It is important to distinguish between illiquid securities and those that are non-marketable. Illiquid securities may be freely bought from or sold to other investors however, transactions may not occur often and the amount of shares traded is usually small. Non-marketable securities, on the other hand, are limiting by design as they generally cannot be sold to outside investors either for a certain period of time after the initial investment or during the entire life of the investment.

When you invest in non-marketable securities, you are essentially placing a bet that your particular investment will outperform other available alternatives in the current year and in future years. This means that if a security is said to provide, let’s say, a steady 6% annual return on average, then you would essentially miss out on any returns provided by the market which exceed that 6%. If the market returns 10% in a given year, then the 4% difference is effectively the cost you pay for holding an inflexible investment.

On the other hand, that 6% average annual return may seem much more attractive when the market loses 30%. In this case, it may appear that the non-marketable investment would be paying off. However, the reality of the situation may be more complicated than it appears.

This is due to the fact that a security which promises a steady return is only as reliable as its intended source of income. In other words, the security may only provide returns to investors if it generates sufficient revenue through its underlying investments. This means that despite the steady distributions which may be touted by an issuer of non-marketable securities, it is rarely the case that an investment is completely immune to events occurring in the financial markets. As a result, significant market downturns may affect the ability of an issuer to make distributions to investors and/or protect their principal, even in situations in which the issuer promises stable, fixed returns. The investor may not become aware of this, however, until it comes time to cash out of the investment.

To illustrate this point, let’s consider non-marketable REITs (Real Estate Investment Trusts) as an example. A REIT is an investment vehicle which gives investors an opportunity to participate in the revenue earned from the hotels, office buildings, residential properties, interests in mortgage securities and/or other assets held by the Trust. Essentially, investors act as a conduit and provide the REIT with the capital needed to purchase the underlying assets with the intent of collecting future payouts.

As the process of purchasing and selling real estate can be quite complex, time-consuming, and costly, REITs often require investors to lock in their investment for a certain period of time before they can exchange their shares for cash. While this brings stability to the overall portfolio held by the REIT, investors may be paying the price for this stability by way of their long-term financial commitment.

This is because property prices, as most other variables in the financial markets, are subject to change. In the rapid pace and high liquidity of the stock market, such changes may be reflected almost immediately by decreases in the market values of securities relating to real estate. To illustrate this concept, consider an investor who purchased shares of a publicly-traded real estate company at $10 per share. In the event of a market downturn, each share may be worth only $8. This drop in price was the result of a consensus amongst a multitude of buyers and sellers who agreed that the fair value of the security at a particular time was $8 per share. Although the investment has dropped in value, the investor has the benefit of transparency regarding the price of the shares at a particular time, and also the ability to cash out if the losses exceed a certain predetermined threshold (also known as a stop-loss).

However, non-marketable REIT securities are not as transparent in this respect because the marketplace is comprised solely of the issuer and the investor. Therefore, the price may not be reflective of significant macro and microeconomic forces which would ordinarily influence the prices of marketable securities. Since the volume of transactions occurring within a given time period is usually quite small, changes in prices take longer to be priced into the value of a non-marketable REIT.

So for example, let’s say that one million investors bought a single share of a non-marketable REIT at $10 in 2006. The REIT could use these proceeds, up to $10 million, to purchase real property, mortgages, etc. This security can provide distributions to investors which are fueled by rents, leases, mortgage payments, and other capital inflows to the REIT. Suppose that after the financial crisis, the value of the property originally purchased by the REIT at $10 million drops to only $6 million. As investors attempt to redeem the shares that they paid $10 for in 2006, the REIT will only be able to pay out $6 per share. Even though investors received distributions from the investment, the value of the principal was significantly reduced over the years. Unfortunately, this may not be apparent to investors until it comes time to cash out their principal.

In this case, the $10 share price may not necessarily reflect the true value at a particular time because there are no recent trades between market participants to serve as a basis for that price. This is because issuers of non-marketable securities typically prohibit sales of interests to third-parties, which means that the security essentially does not exist outside of the agreement between the investor and the issuer.

As a result, investors holding non-marketable securities should carefully consider the share prices which are quoted to them and shown on account statements. If a particular security was quoted at $10 prior to the collapse of the recent financial bubble, it may be unrealistic to maintain the $10 valuation given that the prices of the underlying investments have fallen significantly.

It may be argued that since investors are receiving regular distributions from non-marketable investments, they need not consider current market prices. This logic is flawed, however, because the investors are relying heavily on the financial health and the investment success of the issuer to protect their principal. If the market prices of any underlying investments fall significantly, it may in extreme cases lead to the insolvency and/or bankruptcy of the issuer because it may not be able to buy back the shares from investors at the quoted prices. In such cases, investors in non-marketable securities may be left with pennies on the dollar as they are typically not insured against losses.

Aside from the risks associated with investing in non-marketable securities, investors should also consider the fees that are charged when entering in such investments. These fees may include commissions paid to financial professionals who profit based on volume of securities they sell. These commissions may in some cases result in conflicts of interest and cause non-marketable securities to be recommended to investors over other, potentially less risky investments.

With the wide variety of investment options currently available in the financial markets, investors may be better served by emphasizing liquidity and transparency when making their investment decisions. There are many alternatives available which may provide comparable returns with a lower level of risk than is available with non-marketable securities. If considering the purchase of a non-marketable security, an investor should consider whether the returns provided by the investment adequately compensate the investor for taking on the additional risk of holding the security while other, more lucrative alternatives may be available. The investor should also be mindful of the financial stability of the issuer, which can be a significant factor in influencing the outcome of the investment.

The purpose of this article is to provide insights without jargon and in plain English. As such, this article does not provide a comprehensive overview of all of the risks and benefits associated with non-marketable or illiquid securities. However, consideration of the risks outlined may help investors find securities which are more suited to their investment goals and objectives. Please note that REITs are just one of the many types of non-marketable securities currently being sold to investors. While some REITs are non-marketable, there are also marketable REITs that offer additional liquidity and those that are publicly-traded on established national stock exchanges.