Brian Moriarty and Jack Shannon: Putting Private Markets Funds Through Their Paces

Key Concepts

• Private Markets: Investments occurring outside public exchanges (e.g., private equity, private credit), characterized by limited transparency and restricted liquidity.
• Semi-Liquid Funds: Investment vehicles (Interval funds, Tender offer funds, unlisted BDCs, unlisted REITs) designed to offer retail investors periodic liquidity for private market assets.
• Liquidity Waterfall: A mechanism used by funds to manage redemption requests, often involving cash, liquid assets, or lines of credit.
• Payment-in-Kind (PIK): A loan structure where interest is paid in additional debt rather than cash. "Good PIK" aligns with project cash flows; "Bad PIK" often signals borrower distress.
• Phantom Returns: Apparent gains in private portfolios resulting from accounting maneuvers (e.g., marking up secondary fund purchases to NAV) rather than realized cash flows.
• Two Wolves Concept: A cultural framework describing the tension between a firm’s "Deal Team" (focused on sourcing new investments) and its "Investment/Perpetual Team" (focused on managing existing fund liquidity and investor outcomes).
• Incentive Fees: Performance-based fees that, in many private funds, are structured to be collected regardless of market conditions, often acting as a "participation trophy" rather than a true performance incentive.

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1. Overview of Private Markets and Access Vehicles

Private markets have grown significantly since 2020, with asset managers increasingly offering products to retail investors through "semi-liquid" structures. These vehicles—such as interval funds and unlisted Business Development Companies (BDCs)—attempt to provide a familiar experience to mutual fund investors while holding illiquid assets. Morning Star emphasizes that these funds are not truly liquid; they offer periodic redemption windows (quarterly, monthly, or annually) that can be strained if a large percentage of investors (e.g., 15–20%) attempt to exit simultaneously.

2. The Due Diligence Framework: The "Ps"

Morning Star applies a rigorous due diligence process to these funds, focusing on four key pillars:

• Process: The core focus is on the durability and repeatability of the investment strategy. A critical differentiator is how managers handle the "liquidity mismatch"—the gap between the liquidity promised to investors and the liquidity of the underlying assets. Managers must often hold a "liquidity sleeve" (cash or syndicated loans), which creates a trade-off: higher liquidity usually results in lower returns.
• People: Unlike public equity teams, which often feature a singular Portfolio Manager, private market teams are frequently structured as "deal teams." Morning Star looks for stable teams, intellectual honesty regarding risk metrics, and "skin in the game" (personal investment in the fund).
• Parent/Culture: The "Two Wolves" analogy is central here. Firms must balance the culture of the deal-makers with the culture of the portfolio managers. If the firm prioritizes deal-sourcing over the maintenance and risk management of existing assets, it can lead to poor outcomes for retail investors.
• Price: These products are significantly more expensive than public equivalents. Morning Star advocates for a "total cost of ownership" analysis, which includes management fees, incentive fees, and the cost of leverage.

3. Valuation and Risk Management

Valuation in private markets is inherently opaque. Because these assets are not marked-to-market daily, they often exhibit lower volatility than public markets—a feature that can be misleading.

• Valuation Gaming: Managers may avoid marking assets down to maintain the appearance of low volatility, which is a key selling point for these funds.
• Leverage: Leverage is often used to amplify returns, but it also exacerbates downside risk. Morning Star notes that in some cases, leverage accounts for the entirety of a fund's excess return over public benchmarks.
• Standard Deviation: This metric is largely ineffective in private markets. Morning Star prefers looking at "non-accruals" (defaults), interest coverage ratios, and the percentage of PIK income to assess true risk.

4. Key Arguments and Perspectives

• The Access Fallacy: Brian Morardi argues that "access" to private markets should not be the sole reason for investment. Investors are sacrificing liquidity and should demand a clear "illiquidity premium" in the form of excess returns.
• The Liquidity Reality: Jack Shannon notes that many managers have "oversold" the liquidity of these products. If a fund cannot generate organic liquidity from its underlying assets, it may be forced to rely on lines of credit, which creates systemic risk during market downturns.
• Fee Transparency: Morning Star is developing methodologies to standardize fee disclosures, as many prospectuses use "dashed-out" incentive fee tables that obscure the true cost to the investor.

5. Notable Quotes

• Jeff Gunlock (via Brian Morardi): "There are only two marks in private credit markets: 100 and zero."
• Brian Morardi on the "Two Wolves": "If the deal team is the bigger, hungrier wolf, I think that can have an impact on the culture of the firm and how they think about managing these products."

6. Synthesis and Conclusion

The primary takeaway is that while private market funds offer diversification, they are complex, costly, and carry significant liquidity risks that are often masked by infrequent valuations. Morning Star’s "Medalist" ratings are rare in this space because many funds fail to demonstrate that they can consistently outperform public market equivalents after accounting for high fees and the loss of liquidity. Investors are cautioned to look past marketing materials and focus on the underlying portfolio quality, the firm's cultural alignment with investors, and the true, standardized cost of ownership.