The Problem with Private Markets

Key Concepts

• Private Markets: Investments in assets not listed on public exchanges (Private Equity, Private Credit, Private Real Estate).
• Illiquidity: The inability to easily sell an asset for cash without a significant discount or delay.
• Volatility Laundering: The practice of using infrequent valuations to make an asset appear less volatile than it actually is.
• Gating: A mechanism where fund managers restrict or halt investor redemptions (withdrawals) due to liquidity constraints.
• NAV (Net Asset Value): The reported value of a fund's assets minus its liabilities.
• Evergreen Funds: Semi-liquid vehicles that allow retail investors access to private assets, often used to provide exit liquidity for older, maturing funds.
• Continuation Funds: Vehicles created by private equity managers to buy assets from their own existing funds, effectively extending the holding period.
• Adverse Selection: A situation where retail investors may be buying into assets that institutional investors are trying to offload.

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1. The Core Argument: The "Private Market" Myth

Ben Felix argues that private markets are being sold on a false premise: that they offer higher returns with lower risk compared to public markets. He contends that this is economically impossible, as risk and return are inherently linked. The "low volatility" observed in private assets is largely an illusion caused by infrequent valuation (the "valuation lag") rather than actual stability.

2. Asset Class Breakdown

Private Equity (PE)

• Mechanism: PE firms acquire companies, improve them, and exit for a profit.
• The Problem: Net-of-fee returns are often in line with public markets, meaning the managers—not the investors—capture the value of the skill involved.
• Current Issues:
  • Continuation Funds: Managers are selling assets to themselves (via evergreen funds) to create liquidity, which creates a conflict of interest and potential "lemon" assets for new investors.
  • NAV Squeezing: Universities are selling PE stakes at deep discounts (averaging 11%) to secondary buyers. These buyers then mark the assets back up to the original NAV, creating "paper" returns that don't reflect underlying economic reality.
  • Fee Changes: Some managers (e.g., Hamilton Lane) have shifted to collecting performance fees on unrealized gains, potentially signaling that they fear current valuations will not hold.

Private Credit

• Mechanism: Non-bank entities provide loans to private companies.
• The Problem: These loans are inherently risky. When public markets become volatile, private credit funds often "gate" redemptions because they cannot sell the underlying loans.
• Real-World Application: Publicly traded Business Development Companies (BDCs) provide a "truth serum" for the sector; when they mark down loans, their share prices drop significantly, revealing the true risk that unlisted private credit funds hide.
• Insurance Shenanigans: PE firms are buying insurance companies and stuffing their portfolios with private credit to chase yield, creating a "closed loop of risk."

Private Real Estate

• Mechanism: Direct ownership of physical properties (office towers, malls).
• The Problem: Similar to PE and credit, these funds are gating redemptions as property values decline.
• Evidence: When private real estate funds go public (IPO), they often see their share prices crash immediately (e.g., Blue Rock’s fund dropped nearly 40% on its first day of trading), proving that the "low volatility" was merely a lack of price discovery.

3. Key Arguments and Evidence

• The Yale Endowment Case: While often cited as the gold standard for private market success, Felix notes that their reported returns were often based on IRR (Internal Rate of Return), which can be misleading.
• Public vs. Private Equivalence: Research (2018/2019) suggests that private real estate and private equity returns can be largely replicated using public market factors (e.g., small-cap value stocks and high-yield bonds).
• The Retail Trap: Financial institutions are pushing these products to retail investors to replace the revenue lost from the shift toward low-cost index funds. Retail investors are often the "last ones to the party," buying illiquid assets that institutional investors are trying to exit.

4. Notable Quotes

• "You don't get to see the volatility, so you're going to get illiquidity."
• "If this whole thing smells a little bit fishy, I think you've got a good nose."
• "It's an interesting question whether it's worse to live with volatility but always have access to your money... or to be artificially shielded from volatility while potentially being denied the option to sell."

5. Synthesis and Conclusion

The current "wake-up call" in private markets is a natural consequence of high interest rates and economic stress. The primary takeaway is that liquidity is a feature of public markets that investors pay for with volatility. By choosing private markets, investors are not avoiding risk; they are merely trading visible market volatility for hidden valuation risk and the potential for total illiquidity. Felix concludes that for most investors, the high fees and complexity of private markets are not compensated by superior risk-adjusted returns.