Mark to Market vs. Mark to Fantasy – Dividend Cafe – December 9

Dear Valued Clients and Friends,

It’s a crazy time in the ‘bizarro’ world when we have questions that we do about 2023’s economic health, the earnings environment, and financial markets liquidity, and yet one of the biggest stories in financial media for the week centers around a couple of obscure income real estate portfolios.  Indeed, one could argue it is truly a ‘bizarro’ world when what appears to be one of the largest frauds and wealth evaporations in history (FTX) provides a pretty glowing media tour while some of the most successful wealth creation and capital markets success in history is given the third degree by the same people.

But today’s Dividend Cafe is not about Blackstone or Starwood or FTX or CNBC, or any other particular asset manager, crypto scam, or media outlet.  Rather it is about a broad issue in financial markets that is not understood, needs to be understood, and has no chance of being understood given the fact that the people doing the educating do not understand.

So let’s jump into the Dividend Cafe.  Mark this moment.  The lesson will not prove to be over-valued.

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Private Investing and Today’s Topic

What we are not talking about today is private market investing.  I wrote about it eight months ago and loved that edition of Dividend Cafe.  The topics overlap, but the general case for private equity (and private debt) remains in full effect.

The question today has to do with the relevance to the investing process of “price discovery” and what risks and opportunities exist when prices (that is, the “market value”) are hard to come by.

Have Water, Will Price

Of course, there is no issue getting a “price” when there are a “bunch of buys and sells” …  (that is my explanation of what we call “liquidity”).  When Microsoft trades 23 million shares of stock per day, it is not difficult to get stock, to get rid of stock, or to get an idea of what the price will be in doing so.

Most companies do not trade on a public exchange.  You don’t know what The Bahnsen Group is worth because (a) I’m not selling, and (b) I’m not telling you.  You can guess when you drive by your neighbor’s kid’s lemonade stand that it may not have a high enterprise value, but you don’t have an easy way to access shares even if you did want some.

Liquidity and price discovery go hand in hand.  We know what something is worth by the clearing price at which it trades.  This entire issue becomes obsolete when we have market clearing prices (that is, the price discovery of a transaction).

But without “liquidity,” then “prices” become a different animal.

Who wants to buy something that can’t be sold?

Rich people who want to get richer, that’s who.  The vast majority of wealth creation in our country has always come from what was illiquid on entry and became liquid in some manner upon exit.  Real estate.  Concentrated insider stock.  Employer stock options.  Private businesses.  Entrepreneurial endeavors.  Venture capital.  Illiquidity is a feature, not a bug, for those with experience in wealth creation.

Why does the price of an illiquid investment matter?

There are a few reasons to cover here, but I have to be honest and candid with you.  The NUMBER ONE reason “pricing illiquidity” matters is some synthesis of ego and insecurity.  Sorry.  But it is true.  People LOVE being able to see on a screen and tell people that they have a certain ownership value, regardless of its connection to reality.  I learned in the housing bubble of 2002-2006 that there really was a “wealth effect” – even if it was not the one Alan Greenspan believed in.  Rather, it was a pathology that helped someone worth about $25,000 to tell themselves (and maybe others) that they were a millionaire.  Good times.

When one puts $100,000 into a private business, a start-up, a venture investment, or any other form of illiquid, long-term unknown outcome, you can tell your QuickBooks you have $100,000 (mark-to-purchase), or you can tell it you have $0 (mark-to-current sale value), and both have a kernel of truth.  But you can also say you have $150,000 (mark-to-fantasy), and neither you nor anyone else can falsify your declaration.  That is a great way to grow your net worth by 50%.  Do it enough times, and you may even be President someday!

But there are legitimate reasons some form of “price” may matter in illiquidity.  A bank may want a “reasonable” estimate of your net worth before loaning your money, and some form of appraised value is useful in getting an idea of your financial position.  Of course, get enough value in the balance sheet that is illiquid with enough debt that on the balance sheet that is liquid, and voila, you may very well have a true solvency problem.  The fine line between solvency and liquidity is generally more precarious than anyone ever wants to admit, but that is only true because of debt and leverage.  Illiquidity can never threaten solvency without leverage.  Write that one down.  Maybe I could be President someday.

Okay.  Where was I?  Oh yes.  Legitimate reasons for pricing illiquidity.

(1) Bank needs around the financial position

(2) Estate planning

(3) Fees charged by the manager of the illiquid investment

(4) Interested in converting illiquidity into liquidity

So some sense of pricing illiquidity can make sense, but it can never be that good or precise.  Only market-clearing liquidity provides the price discovery we are used to when we go to the grocery store or buy a public stock on an exchange.

So what’s the beef?

What if you develop a strategy of ILLIQUID investments and put them in a fund that you decide to make LIQUID?  Well, some people think that sounds like a great idea.  There are a bunch of benefits of illiquidity (“fancy rich people do this stuff”), and yet we all love liquidity (“I may need the money next month”).  What could go wrong with blending these two things?

I will argue that in the present context, there are three people, and one of them is not exposed, while two are.

(1) The investor who bought a great illiquid, long-term investment and decides they need their money back in a month.  They may get a bad price.  They may not get their money back because the fund manager says, “we only said monthly liquidity up to a certain number; that number has been exceeded,” so now your dream of sodium-free french fries has died.  They may get filled and then miss the real long-term value creation they initially invested for.  But if they mismatched their investment action (liquidity) with investment reality (illiquidity), they are exposed.

(2) The asset manager who invested in illiquid investments and promised liquid treatment.  Now, they may have protected themselves by saying, “we can sell you out up to a certain level” or “we will do the best we can,” but in the real world, people hear what they want to hear (note to self – write a book someday).  So you either get away with a mismatch of liquid commitments from illiquid assets because no one asks for liquidity, or you are legally protected because you set a cap but then reputationally exposed because people say, “you thought I read that?  come on, give me my money back!”

(3) The third person should be fine.  Are you ready for it?  It is that investor who bought an illiquid investment with the intention of keeping it for a long time.  Whoa!  Why would anyone buy a portfolio of elegant income-producing assets managed by a sophisticated and competent management team generating great net operating income in a tax-efficient manner and expect to stay in the investment for a long time?  What are they supposed to do, miss out on dogecoins and the chance to buy a Bahamas-based cryptocurrency exchange?  But yes, in theory, there still exists these brave souls interested in long-term value creation and income growth.  I would suggest that person #3 on this list is sitting pretty through the headlines, achieving genuine capital accumulation, while the media and person #1 fret over something that was entirely their own doing.

Dude – some people need the money

I am not new to managing client capital.  The liquidity needs of some investors are different from the liquidity needs of many institutional investors or more sophisticated and resourced ones.  I understand that sometimes people need access to their capital.  I also realize that oftentimes “liquidity” is not about needing money but rather “behaving badly” (selling out of good investments in bad times or allowing panic/fear/media/human nature to drive the ship).  But obviously, liquidity can be important.  What to do with these investments that have certain “illiquid” dynamics but “liquid” features?

A quick back-of-napkin set of suggestions:

(1) If someone presented it to you like it was calorie-free ice cream, do not buy it.  Risk-free returns and cost-free liquidity do not exist (in this world or the next; scarcity and trade-offs were Edenic realities, too, for those theologically minded).  Those who tell you something like this – that you can have illiquidity and liquidity all blended together with no cost or concern or caveat are either intellectually unworthy of your business or morally unworthy of the financial advice industry.

(2) If there is an investment that offers some liquidity around what seems like illiquidity in the portfolio, consider the continuum of reality – daily liquidity is a farce, monthly liquidity may be more problematic, quarterly becomes more theoretically possible, and annual liquidity is much better.  Again, I am not talking about what is “better” for you – I am talking about what is better for “reality.”  Grown-up stuff.  Consider moving out of the liquidity spectrum to match your expectation to reality.

(3) Understand the downside, and embrace asset manager caveats!  You. Do. Not. Want. An. Asset. Manager. Giving. You. Liquidity. When. They. Can’t.  When they talk about “gates,” “limits,” and “restrictions,” that sounds punitive when in reality, it is protective.  I think I could sell the Bellagio Hotel for $6 billion over the next year.  But if I have to sell it in 30 days, I may get $2 billion.  One man’s liquidity is another man’s wealth creation.  Don’t be invested in a forced seller, ever.  And don’t be a forced seller, ever.

(4) Institutional asset management quality matters.  Some are better than others.  Some lie, and some don’t.  Some promise you they will stop carbon emissions, while others promise you dependable investment returns.  Some have thought through the mismatch of liquidity and illiquidity, and some have promised you lima beans that taste good because they need your $100,000 investment.

Invest with the manager who doesn’t need your $100,000.  Invest with the manager who knows lima beans are disgusting.


People have not blown up in FTX and other crypto exchanges because of illiquidity.  Money moved where it shouldn’t have, and real capital got replaced by worthless investments (digital coins, etc.).  You can destroy wealth by setting it on fire, and you can destroy wealth by substituting something of value for something that becomes valueless.  It is not uncommon, but it is tragic.

People do not blow up merely because of illiquidity when (a) The underlying investment maintains a path to value creation, (b) The underlying investment creates an internal rate of return, (c) One’s debt profile is properly managed, and (d) Sufficient understanding of and adherence to the limitations of liquidity in a given investment are present.

We are living through a tale of two cities in financial media.

I want to burn the first city down with every ounce of breath in my body.  But I will buy all the real estate I can in the second city.  Someone should start a fund.

Chart of the Week

A warehouse that collects a rent check from a tenant is a warehouse that collects a rent check from a tenant.  The same is true of a hotel landlord and a multi-family apartment building landlord.  You have an underlying asset with an assumed exit value (the presumed exit value gives you the cap rate, or a presumed cap rate gives you the exit value; value one variable and the other variable is solved via math).  Net Operating Income is the crucial variable that drives cap rates and exit values.  So if buildings are buildings, why the crazy difference in value volatility in public vs. private real estate returns?

Second-by-second liquidity versus illiquidity.  One is focused on rationality and economics.  One is focused on access to funds.  Use your imagination.

*Blackstone, Real Estate Symposium 2022, October 13, 2022

Quote of the Week

“One of the ironies of the stock market is the emphasis on activity. Brokers, using terms such as ‘marketability’ and ‘liquidity,’ sing the praises of companies with high share turnover… but investors should understand that what is good for the croupier is not good for the customer. A hyperactive stock market is the pick pocket of enterprise.”

~ Warren Buffett

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I hope you found value in this week’s Dividend Cafe, and I hope you will reach out if you have any questions.  I enjoyed writing it, and I want you to enjoy reading it.  And more important than anything else, if you are a client of TBG, I want you to receive the fiduciary care, information, and advice you deserve.  If you are not a client of TBG, I want you to at least be more informed than you were 20 minutes ago and to reach out if you want to understand better.

We are living in a fallen world of sharks, fraudsters, liars, and reporters.  And yet, through it all, thick and thin, liquid and illiquid, we are never going to change who we are.  To that end, we work.

With regards,

David L. Bahnsen
Chief Investment Officer, Managing Partner

The Bahnsen Group

This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet


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About the Author

David L. Bahnsen

David is a frequent guest on CNBC, Bloomberg, and Fox Business and is a regular contributor to National Review and Forbes. David serves on the Board of Directors for the National Review Institute and is a founding Trustee for Pacifica Christian High School of Orange County.

He is the author of the books, Crisis of Responsibility: Our Cultural Addiction to Blame and How You Can Cure It (Post Hill Press), The Case for Dividend Growth: Investing in a Post-Crisis World (Post Hill Press) and his latest, Elizabeth Warren: How Her Presidency Would Destroy the Middle Class and the American Dream (2020).