Private Markets Face Reckoning: Illiquidity, High Fees Exposed

Private Markets Face Reckoning: Illiquidity, High Fees Exposed

After years of operating behind a veil of mystique and illiquidity, the private markets—encompassing private equity, private credit, and private real estate—are being scrutinized as never before. These asset classes have been aggressively marketed to investors with the promise of higher returns and lower risk compared to public markets. However, recent events are forcing a re-evaluation of these claims, suggesting that caution is indeed warranted, particularly as these investments become more accessible to retail investors.

The Illusion of Lower Volatility

A core tenet of the private market sales pitch has been their perceived lower volatility. This perception stems from the fact that private assets are not traded on public exchanges and are valued infrequently. Unlike publicly traded stocks, bonds, or Real Estate Investment Trusts (REITs), whose prices fluctuate throughout the day, private assets offer a smoother, less volatile reported return. However, experts argue that this is an illusion, a phenomenon sometimes referred to as “volatility laundering.” The underlying economic risks can be significant, even if they are not immediately reflected in daily valuations.

“Just because you don’t see the price change every day like you do with public stocks doesn’t mean the asset’s value isn’t fluctuating. A private equity fund may look stable on paper while the underlying economic risks are exactly the same as or even worse than public market equivalents.”

This lack of daily price discovery means that when investors finally demand liquidity, they may face a stark reality: either denied access to their capital or forced to sell at a substantial discount. The choice, experts suggest, is between enduring market volatility with constant access to funds or being artificially shielded from short-term fluctuations only to risk being locked out when liquidity is most needed.

Private Equity’s Mounting Challenges

Private equity, which involves investing in private companies with the aim of increasing their value and exiting at a profit, is currently grappling with significant headwinds. A primary issue is the difficulty many funds are experiencing in selling their underlying holdings. This challenge is compounded by high fees, which can significantly erode net returns. While before-fee returns for private equity have historically been impressive, net-of-fee returns, after accounting for management and performance fees often totaling around 6%, have been shown to be largely in line with risk-matched public market equivalents.

To address the liquidity crunch, private equity firms are increasingly employing strategies like continuation funds, where a new fund buys assets from an existing fund, often managed by the same firm. Evergreen funds, semi-liquid vehicles accessible to retail investors, are becoming common investors in these continuation funds. However, this creates a potential conflict of interest, as the fund manager may control both sides of the transaction, raising concerns about the accuracy of valuations and the risk of investors acquiring assets that the broader market has rejected.

Another emerging problem is “NAV squeezing.” Institutional investors, such as university endowments like Yale and Harvard, which historically favored private equity due to its perceived long-term return potential, are now being forced to sell their stakes at discounts averaging around 11% to meet operational needs. These stakes are then often immediately marked back up to their original Net Asset Value (NAV) by the secondary buyers, creating an artificial, immediate paper gain for the buyer without any change in the underlying asset’s value. This practice, coupled with fee structures that allow managers to collect performance fees on unrealized gains, raises questions about the true value and sustainability of these reported returns.

Furthermore, private equity’s heavy concentration in software companies, a sector reliant on robust corporate spending, is proving problematic in the current economic climate. The playbook of leveraging buyouts for Software-as-a-Service (SaaS) businesses is faltering, impacting not only private equity but also the private credit sector that often finances these deals.

Private Credit’s Liquidity Squeeze

Private credit, which involves loans to private companies made by non-bank entities, is experiencing its own set of difficulties. These loans, often structured with flexible terms, are inherently risky. Like private equity, private credit funds do not mark their assets to market daily, allowing them to appear less volatile than they might be. However, as investors have sought to redeem their funds, many private credit funds have been forced to “gate” redemptions, effectively locking up investor capital.

The risk becomes apparent when comparing these unlisted funds to publicly traded Business Development Companies (BDCs). For instance, FS KKR Capital Corporation and Midcap Financial Investment Corp, both publicly traded BDCs, have seen their share prices decline significantly as they’ve had to acknowledge troubled loans and reduced investment income, reflecting the market’s assessment of their underlying assets. This contrasts sharply with the opaque nature of private credit funds, where such market-driven valuations are absent until a liquidity crisis forces the issue.

An increasingly concerning trend involves private equity firms acquiring insurance companies and redirecting their conservative investment portfolios into private credit for higher yields, often from lenders owned by the same private equity firm. This creates a closed loop of risk, where potential defaults in private loans could have significant repercussions for insurance policyholders.

Private Real Estate Faces Price Discovery

Private real estate funds, which directly own physical assets like buildings and malls, are also encountering liquidity challenges, particularly in markets like Canada where real estate prices have seen significant declines. Fund managers, unwilling to sell assets at depressed prices, are utilizing contractual clauses to gate redemptions. Some of these funds are now considering going public as a means to provide liquidity. However, as seen in the U.S., when such funds transition to public markets, they often experience substantial price drops as their NAV is subjected to market price discovery. Funds like FS Specialty Lending Fund and Blue Rock’s Total Income Plus Real Estate Fund saw significant declines on their first day of public trading, highlighting the disconnect between internal valuations and market reality.

Research suggests that when valuation lags are accounted for, private REITs behave similarly to public REITs and a combination of stocks and bonds. The promise of unique returns in private real estate, separate from public market factors, appears to be largely unsubstantiated.

What Investors Should Know

The current environment is revealing that private market investments, often touted as safer and more lucrative alternatives to public markets, carry significant risks. These include:

• Illiquidity: Investors may find their capital locked up for extended periods, especially during market stress.
• High Fees: Substantial management and performance fees can significantly diminish net returns, often negating any outperformance.
• Valuation Opacity: Infrequent valuations mask underlying volatility and can lead to misleading performance reporting.
• Conflicts of Interest: In areas like continuation funds and insurance company investments, managers may have incentives that do not align with investor interests.
• Adverse Selection: Retail investors, often entering the market later, may be inadvertently buying assets that institutional investors are eager to offload.

While the allure of higher returns and lower risk in private markets persists, the recent performance and structural issues suggest that investors, particularly retail investors, should approach these asset classes with extreme caution. The evidence indicates that the sales pitch often does not match the economic reality, and the premium for illiquidity and complexity may not be adequately compensated.

Source: The Problem with Private Markets (YouTube)