This article was first published in the National Post on June 24, 2023. It is being republished with permission.

by Tom Bradley

We’re used to being able to sell a fund or stock at the drop of a hat, but some investors are finding out it’s not always so easy. Holders of some real estate and mortgage funds, including ones managed by Ninepoint Partners LP, Romspen Investment Corp., Hazelview Investments and even the mighty BlackRock are being told they must get in line to take their money out.

Before we address their situation, let’s take a step back and put these funds in context.

These investors are trying to earn a return from owning alternative asset classes, real estate and mortgages. In doing so, they’re also capturing what’s called a ‘liquidity premium.’

Liquidity is the least known of the four risks investors use to generate returns in excess of the risk-free rate (that is, Government of Canada T-bills). The first three are: interest rate risk, credit or default risk and equity risk. The fourth involves accepting limited liquidity in return for a higher potential return.

Instead of buying public companies on the stock exchange, you can invest in a professionally managed fund, known as a private-equity fund, that owns private companies.

You can do the same with debt instruments. You can own a fund or exchange-traded fund that holds easily tradable government and corporate bonds, or invest with a private debt manager and get exposure to a portfolio of higher-yielding private loans.

In the real estate category, you can buy real estate investment trusts (REITs) or a private fund that owns individual properties.

Where do the extra returns come from for going private? Managing companies outside the public eye, and the quarterly reporting cycle, allows fund managers to take a longer view. They can buy out-of-favour or underperforming assets, rehabilitate them and sometimes re-position them in the market, or build scale by consolidating fragmented industries. They also have more flexibility to use debt to enhance returns and minimize taxes.

Previously, private assets were only accessible to institutional investors, but there’s been a push in recent years to make them available to individuals. The challenge with retail-izing private assets, however, is it creates a mismatch. The funds are designed to be tradable like other retail products, but largely hold assets that are slow to transact. In other words, liquid products invested in illiquid assets.

This mismatch isn’t a problem in good times when money is flowing in. It only comes into play when the outlook deteriorates and there’s a surge of redemptions, which we’re starting to see now.

The sentiment towards real estate has changed. REITs, particularly those exposed to office and retail, are well off their early 2022 highs. But property values in private funds haven’t reduced to the same degree. This, despite many of them excitedly talking about the opportunities to buy other properties at reduced prices.

This valuation lag is actively being debated. Are REIT shareholders overreacting such that private valuations better reflect long-term fundamentals, or are private fund managers deluding themselves? The truth may be somewhere in between.

Long-term returns will tell the tale, but in the meantime, there are consequences to the gap.

First, it has helped smooth out returns for portfolios holding private assets. They weren’t down nearly as much in 2022 because privates held up better than bonds and stocks, which immediately reacted to rising interest rates. In 2023, the opposite is occurring. Stocks are up while private asset classes are now adjusting to the higher rate environment.

Second, the valuation lag has contributed to the liquidity problem funds are having. If investors can sell a yet-to-be-marked-down private fund and buy an already-marked-down public company, why wouldn’t they? Sell expensive and buy cheap.

Capturing the liquidity premium makes sense for part of your portfolio, but the challenge currently being experienced by private funds is a reminder that there’s no free lunch with this type of risk.

You should buy private assets with the expectation that the money will be unavailable for the term of the product, or will at least take time to liquidate if you decide to exit sooner.

As with any risk, make sure you’re getting paid for it. If you’re tying up money for a long time, there needs to be potential for significantly higher returns.

You should also be leery of products investing in illiquid asset classes that are easily tradable. If you want the manager to deliver good results, the structure should be truly illiquid.