The Problem with Private Markets

Summary

In this video, Ben Felix, CIO at PWL Capital, critiques the current state of private markets—private equity, credit, and real estate. He argues that these investments, often marketed as low-risk with high returns, are actually fraught with illiquidity, high fees, and hidden risks. Retail investors, in particular, are increasingly being pushed into these complex asset classes without a full understanding of their volatility. Felix urges caution, pointing out that private assets are no safer than public markets, despite the promises made by fund managers. He highlights the importance of transparency and careful decision-making in these volatile times.

Takeaways

• 😀 Private markets, including private equity, private credit, and private real estate, have become more accessible to retail investors, but caution is advised due to the risks involved.
• 😀 The premise that private assets offer higher returns with lower risk has been increasingly questioned as private markets face liquidity issues and high fees.
• 😀 Many private equity funds are struggling to sell their holdings, sometimes resorting to creative solutions like continuation funds to provide liquidity.
• 😀 Private equity investments often look stable on paper, but their value is not regularly marked to market, making them appear less volatile than they really are (a phenomenon called volatility laundering).
• 😀 Despite private equity's high fees, fund managers benefit more from these returns than investors, with the net-of-fee returns often in line with public market equivalents.
• 😀 The rise of private credit has led to a similar situation where illiquidity and risk are hidden behind the lack of daily market pricing, potentially masking underlying problems.
• 😀 Investors in private credit funds often face redemptions being gated, meaning they cannot access their investments during market stress, revealing the hidden risks of these funds.
• 😀 Publicly traded Business Development Companies (BDCs) offer a stark contrast to unlisted private credit funds by reflecting market prices, showing how much risk private credit funds are actually taking.
• 😀 Some private equity funds are creatively using insurance companies to meet liquidity needs, raising concerns about the closed-loop risk this creates for investors.
• 😀 Private real estate funds face similar liquidity issues, especially with the Canadian real estate market experiencing significant declines, leading some funds to consider going public for liquidity, which exposes their true market value.
• 😀 Studies have shown that private equity, private credit, and private real estate do not consistently outperform public market equivalents when adjusted for risk, fees, and valuation lags, questioning the added value of these investments.

Q & A

Why are private assets often marketed as lower risk and higher return than public assets?

Private assets are marketed this way because they are less frequently valued, making them appear less volatile. Investors are also promised higher returns due to their supposed exclusivity and potential for long-term growth.

What is the main issue with the illiquidity of private market investments?

Illiquidity in private markets means that investors often can't access their funds when they need them. Even if the value of the assets fluctuates, it might not be visible to investors until they try to sell or redeem their investment.

What does 'volatility laundering' mean in the context of private equity?

'Volatility laundering' refers to the phenomenon where private equity funds appear less volatile because their underlying assets are not marked to market daily. This makes the funds look stable, despite potentially experiencing fluctuations that aren't reflected until later.

Why are the fees in private equity and private credit considered problematic?

The fees in private equity and private credit are high, typically around 6%, which reduces the net returns for investors. These fees can include management fees, performance fees, and other charges, which make it harder for investors to see the promised higher returns.

What are continuation funds and why might they pose a risk to investors?

Continuation funds are used by private equity firms to transfer their assets to a new fund managed by the same firm, providing liquidity for investors. This can be risky because it might indicate that the firm is struggling to find external buyers for the assets, suggesting that the assets may not be as valuable as initially thought.

What is the role of secondary markets in private equity, and how do they affect investors?

Secondary markets allow investors to sell their stakes in private equity funds. However, these transactions often occur at discounted prices, and the buyers can immediately mark the assets back to their original net asset value (NAV), creating misleading returns on paper. This can disadvantage sellers, who may not get full value for their investments.

How do private credit funds differ from publicly traded bonds?

Private credit funds involve loans to private companies and are illiquid, unlike publicly traded bonds that can be bought and sold in the market. This lack of liquidity can make it difficult for investors to redeem their money, especially in times of economic stress.

Why are retail investors at a disadvantage when investing in private markets?

Retail investors often lack the professional support and long time horizons of institutional investors. They may not fully understand the illiquidity, high fees, and valuation practices of private market investments, which increases their risk.

What happened when private real estate funds were exposed to market price discovery?

When private real estate funds went public, their values were subjected to market price discovery, which led to significant price drops. For example, funds that listed on the New York Stock Exchange experienced massive drawdowns of up to 40%, revealing the risks that had been hidden from investors before.

Do private real estate funds offer superior returns compared to public REITs?

Research suggests that private real estate funds do not provide superior returns compared to public Real Estate Investment Trusts (REITs) once adjusted for differences in leverage and sector composition. In fact, private real estate returns behave similarly to a portfolio of stocks and bonds, meaning there's no unique advantage.