This article was first published in the Globe and Mail on July 27, 2024. It is being republished with permission.

by Tom Bradley

It’s an inconvenient truth about investing: You need to take risk to generate a return in excess of government T-bills or GICs. Of the four risks investors may face, three are well known and used regularly – interest rate, credit and equity risk.

Until recently, the fourth, liquidity risk, was inaccessible to the average investor. I’m referring to private assets that don’t trade on an exchange, such as mortgages, real estate, infrastructure, venture capital, and private loans and businesses. In exchange for reduced liquidity, investors in these categories expect a premium return relative to the public alternatives.

Today, the sentiment toward private investments is running hot. It’s where the cool kids are. Publicly traded securities are so yesterday.

In State Street’s 2024 survey of private markets, 58 per cent of respondents – institutional investors across the globe – said they would be adding to private investments in the next two years.

There’s no doubt private assets can be an excellent return generator and diversifier, but there are trade-offs that all the enthusiasm usually obscures. Here are some things to consider before wading into the private asset market.

Circumstances have changed. Some private equity managers have generated excellent returns over many years. But it’s important to note that, while shrewd deal-making and excellent business management had much to do with that performance, so did some howling tailwinds.

For instance, there didn’t use to be as much competition for assets, private valuations were a fraction of public ones, valuations in general were rising, and debt – which is rocket fuel for most private funds – was cheap and plentiful.

Today, the winds are shifting. The new world for private investments is now characterized by competitive bidding, higher financing costs, more complex corporate structures with added layers of debt, and a public investor who is less willing to buy assets at the drop of a hat.

The structure of private investments has pros and cons. Private investors laud the ability of their managers to operate outside the public eye where they can use more leverage and are able to make changes to their portfolio companies without worrying about a quarterly earnings miss.

But that structure has limitations. A private fund has a defined cycle: Raise money; invest it in the first three years; take four to five years to improve the companies; and three to five years to sell assets and distribute proceeds to investors.

The structure is flexible initially but becomes increasingly restrictive as the maturity date approaches. If the buying period is characterized by high valuations, managers have no choice but to pay up. If the management magic takes longer than expected, or there aren’t ready buyers when it’s time to sell, the clock ticks louder. Managers must then get creative, either asking investors for more time or “passing the parcel” to another private equity fund who, interestingly enough, also professes to buy underexploited assets.

And private funds are expensive to manage. Investment banking and legal costs are high, and there are two layers of executive pay. Management teams at the portfolio companies must have their incentives, and it’s an understatement to say fund managers are well compensated. High fees and profit-sharing are harder to justify as the industry gets commoditized, and there are more second- and third-tier managers.

Beware of the liquidity mismatch. The investment industry has gone through contortions to bring private assets to individual investors under the assumption that for a product to sell, it must offer daily, or at least monthly, liquidity.

The drive to make private assets retail investor-friendly has resulted in a mismatch whereby funds are invested in long-term, not easily tradable assets and yet offer short-term liquidity. The problem with this liquidity mismatch is now revealing itself for some mortgage and real estate funds where investors are queueing up to exit, forcing managers to sell assets when they’d rather be buying.

If you want a avoid this issue and achieve a higher return, you need to accept an investment that has less liquidity.

Public investors rejoice. Given the momentum behind private investing, some commentators worry about the prospects for public securities. They point to the decline in the number of publicly listed companies.

The other side of the coin, however, is that the more capital private managers have to invest, the more demand there will be for companies in your portfolio. There’s still a lot to be said for keeping your costs down and letting the bidders come to you.