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What is liquidity?

How quickly can an investor turn an asset or security into liquidity? In this blog, we examine the obstacles to and importance of achieving liquidity.

As a critical component of any investment framework, liquidity allows public and private market participants to navigate evolving investment opportunities with greater ease and agility. But what happens when dealmakers face difficulty maintaining liquidity due to prolonged market disruptions or shifts in investor behavior?

Today’s liquidity crunch, triggered by a challenging exit environment and other economic factors, has pushed investors to get creative in maintaining liquidity to keep operations running. One of those strategies is investing in the secondary market.

In our Q2 2023 Analyst Note: The Evolution of Private Market Secondaries, PitchBook analysts indicate that global secondary transaction volume jumped from $60 billion in 2020 to a peak of $132 billion in 2021, per Greenhill Global Secondary Market Review as of January 2023. This trend showcases a growing market for manager-led deals with more individualized liquidity options.

In this blog, we explore the importance of liquidity and provide insights on how investors can improve exit strategies and manage liquidity in today’s market.

What is liquidity in investing?

In the world of investing, liquidity takes on distinct characteristics in the public and private markets. Public markets function in open-end funds that allow investors to easily enter and exit positions. Open-end fund structures empower investors through agility, providing ease of adjusting holdings based on changing circumstances and risk tolerance. In contrast, private markets are defined by more restrictive, closed-end fund structures, where capital is generally less liquid. Here, liquidity becomes a question of capital availability—a top priority for investors who need readily available resources to support portfolio companies in financial distress.

Why is liquidity important?

Maintaining liquidity allows investors to effectively respond to market changes, support and fund companies, and capitalize on emerging opportunities.

Without sufficient capital reserves, private equity (PE) and venture capital (VC) firms run the risk of missing lucrative investment opportunities and meeting financial obligations to their investors or limited partners (LPs). Effective deal execution relies on ample cash availability and ensures they cover capital call commitments. For LPs, liquid assets are essential for optimizing cash flow management and meeting debt obligations.

What are examples of liquid assets?

  • As the most liquid asset, cash is an essential component of all cash flow management strategies.
  • Highly liquid public stocks are also easily bought and sold on exchanges. These vehicles include exchange-traded funds (ETFs) and mutual funds that can be traded during market hours.
  • Some commodities such as gold and oil are considered fairly liquid as they have well-established futures and options markets, giving them a high degree of cash convertibility.
  • Some government bonds, such as treasury bonds, can also be converted to cash before maturation.

What are examples of illiquid assets?

  • Private equity investments are not easily converted into cash. On the plus side, these shares are insulated from public market volatility but, with longer investment horizons, realizing returns can take years or decades.
  • Real estate and land are some of the most illiquid assets, which makes them a safe long-term investment. The process of buying, building, and or selling property can take months and involves contracts, intermediaries, and other legal agreements.
  • Due to their unique and specific nature, antiques and art are deemed highly illiquid. Buying and selling these objects often requires expert analysis and a high degree of due diligence.

How is liquidity calculated?

Systems for measuring liquidity aim to identify how leveraged a company is and its ability to meet short-term debt obligations. Depending on the asset class and what is being calculated, liquidity ratios take many different forms.

Current ratio

The current ratio measures a company's assets or its ability to pay off short-term obligations against its current liabilities, typically within a one-year horizon. As the accepted industry metric, a ratio of one or higher means the company can pay off its short-term debt and has more assets versus debt.

Cash ratio

The cash ratio looks at the capacity to pay back debt using cash and cash equivalents—meaning any asset that can be easily converted to cash. This metric divides cash, plus cash equivalents, by all liabilities to estimate how easily the company can pay off short-term debt.

Bid-ask spread

A common calculation for stocks and bonds is the bid-ask spread, found by measuring the difference between the most a buyer is willing to pay, or the "bid," and the lowest value a seller is willing to accept, or the “ask.”

Quick ratio

The quick ratio measures a company's most liquid assets to identify its capacity to meet short-term debt obligations. Unlike the current ratio, this metric excludes inventory or a company's illiquid assets to determine whether it can pay its debt obligations without selling inventory or raising more capital.

Cash flow management

As a related strategy, operating cash flow refers to measuring how much coverage the company has to pay off its debts and continue to grow operations. Cash flow management ensures that businesses have enough liquid assets to cover all debt obligations. Here, companies must balance money owed with money received.

What is liquidity risk?

Liquidity risk occurs when an investor or company is unable to fund operations and meet short-term debt obligations caused by volatile market conditions, mismanagement, or other economic factors. Liquidity management involves extensive plans and processes, including cash flow management and portfolio diversification strategies.

One example of liquidity risk is the recent failure of Silicon Valley Bank (SVB), formerly a leading lender to startups. When SVB couldn’t liquidate government bonds, depositors rushed to retrieve their money which made the bank insolvent.

Why are private market participants investing in the secondary market?

A private market secondary investment occurs when a general partner or limited partner invests its fund’s interest in a more mature fund, accessing profit-generating portfolio companies. In today’s environment, cash-strapped investors are increasingly turning to the secondary market as a means of generating liquidity. Meanwhile, private equity investors are looking for relief from the denominator effect, where the drop in public market valuations created an imbalance in their private market portfolio allocations. The confluence of these factors has driven investor attention to the private equity secondary market.

According to a recent Jefferies report, in 2022, the global secondaries market exceeded $100 billion in value for a second year and is expected to continue its upward trajectory.


The importance of exploring innovative paths to liquidity

Understanding the state of liquidity and finding innovative paths for generating cash helps investors mitigate the follow-on effects of a stunted exit environment.

Planning for IPO events or acquisitions can increase the potential of achieving liquidity for investors. In order to meet cash flow obligations, private market participants need to understand liquidity profiles across private equity and venture capital, including expected investment horizons and exit opportunities.

Leverage PitchBook to improve liquidity strategy

A carefully planned liquidity strategy hinges upon timely transaction and deal data, a robust understanding of market activity, and actionable intel on how startup- or investor-friendly the landscape has become. You can track exit activity, inform income-oriented approaches, and learn from the latest capital market developments with our innovative and agile product features.

PitchBook’s PE-backed IPO and VC-backed IPO indexes help investors contextualize the performance of newly public holdings. Private market participants can leverage verifiable and timely pricing insights to gauge how public market valuation shifts affect private market holdings.

Our VC Exit Predictor empowers investors to identify and analyze funds and startups with a high exit probability. Utilizing machine learning technology and PitchBook’s VC data, our Exit Predictor provides information on VC-backed companies, financing rounds, and investors with insights into startups’ prospects of a successful exit.

Discover our VC Exit Predictor