The Anxiety of Private Markets

I’m writing about private markets again, which may seem odd to long-time readers because we don’t invest in private markets.

I routinely think about private investments for two reasons. First, they’re the hottest topic in our industry—what are you doing about privates? Have you heard of this private or that private?

Second, as I’ve said many times, I’ve invested in some to learn more about them and see if they make sense for clients. We like to say that we eat our own cooking, and my account is a bit like a test kitchen.

I bought a private real estate fund several years ago, and the performance has been good—if you trust the valuations. Valuations are an issue for any investment, but at least in the public markets, thousands, if not millions, of investors, evaluate nearly every security second by second and are willing to put a price on them and then trade them at that price.

In private markets, managers usually hire third parties to put a value on the investments, but those relationships can be pretty cozy.

Let’s say you’re the manager of a private real estate, credit, or equity fund, and you’re paid a percentage of the assets under management. Naturally, you want the prices held high for billing purposes. It’s an inherent conflict.

Now, let’s say you are a third-party valuation firm. Could you be swayed to put a good price on an investment if you thought you’d be fired for putting a bad price on a holding? It’s a delicate dance.

A recent New York Times article questioned whether the prices on some of the assets in a popular private real estate fund were fair. The Times pointed out that the prospectus says, ‘these assumptions [about the valuation] are determined by the Advisor, and reviewed by our independent valuation advisor.’ The capitalized Advisor is the manager, so this sentence effectively says the manager sets the price, and the third-party advisor reviews it.

Okay, let’s say you’re comfortable with the prices the manager and third party are using. In a real estate fund, the assets are usually only valued once per year, unlike the continuous public markets.

Let me immediately concede that public markets aren’t perfect, either. We’ve all heard the story of Mr. Market, the manic-depressive investor who will offer you vastly different prices over such a short period that the business hasn’t had time to change.

If everything is going smoothly, then the issues in the private markets aren’t much of an issue. But things can go haywire in public and private markets alike.

Right now, according to the Financial Times, a second large private real estate fund (not the one I referred to above) is having a hard time.

In this case, investors were withdrawing from the fund, but the manager thought they would die down and didn’t start selling some of the fund’s assets. Now, this fund is drawing heavily on its credit lines to meet heavy redemptions.

One feature of a private investment fund is that it can block investor redemptions, which means the manager doesn’t have to sell the fund’s assets at fair prices. A fire sale doesn’t benefit anyone.

At the same time, managers know that blocking investors from getting their money back is deeply unpopular. The fund I discussed above had to limit withdrawals starting at the end of 2022 and stopped limiting withdrawals a few months ago. It was a good thing for investors in the fund like me, but it was also anxiety-provoking.

I don’t own the second fund, and I’m relieved. I’m even more relieved that we don’t own either fund for clients. In the long run, I suspect they will do fine. Both managers have stellar reputations and are savvy investors.

The issue is that it’s quite clear to me that the investors who bought the fund didn’t really understand the risks. That’s one of the reasons why we don’t invest these funds. I feel like I could tell a client a million times until I’m blue in the face, that they might not get their money back when they want it.

But when it hits the fan, I don’t think people will remember or care that I told them. That’s not a dig on clients either – that’s how I feel right now with the fund that I own. I wish I were the kind of person who didn’t have to learn the hard way (in so many aspects of life), but the only way I’ve come to feel this way is by owning the fund. Reading about it just isn’t the same.

I will keep holding because I might learn something about how funds get through times like this; it’s diversified, has relatively low leverage, and I have a sense of the floor from public markets. But I know my anxiety will continue as I wait for the other shoe to drop, knowing that it may never drop.

I’m just glad that the anxiety is about my own money – I’d be a basket case if it were your money.