The Problem with Private Markets

In this detailed analysis, Ben Felix, Chief Investment Officer at PWL Capital, dismantles the long-standing mystique surrounding private markets. For years, private equity, private credit, and private real estate have been marketed to investors—and increasingly to retail investors—on the premise that they offer superior returns with significantly lower risk than public markets. However, Felix argues that 2024 has served as a critical wake-up call, revealing that these assets are not nearly as "special" as fund managers claim. The central issue is the lack of transparency and liquidity. Because private assets do not trade on public exchanges, they are not subject to daily price discovery. This creates an illusion of stability, a phenomenon Felix describes as "volatility laundering." While the paper value of a fund might appear steady, the underlying economic risks are often identical to, or even greater than, those found in public stocks and bonds. ### The Shift Toward Retail Investors Historically, private markets were the playground of institutional investors like university endowments and pension funds. Recently, however, there has been a massive push to bring these products to retail investors. Felix views this trend with extreme caution. He suggests that financial institutions are driven by two main incentives: the high fees associated with private funds (which help offset the shrinking margins of low-cost index funds) and the need for "exit liquidity." As institutional investors look to reduce their exposure, retail investors are essentially being invited to the party late to buy illiquid assets that others no longer want. ### The Reality of Private Equity Private equity (PE) is built on the promise of diversification and market-beating returns. However, Felix points to research suggesting that PE returns, net of fees, can largely be replicated using public stocks with similar characteristics. The perceived diversification benefit often disappears once returns are adjusted for the fact that private companies aren't valued daily. A significant hurdle for PE investors is the fee structure. Between management fees, performance fees, and other layers, the total cost can reach approximately 6%. While PE managers are undoubtedly skilled, economic theory suggests that the managers—not the investors—reap the rewards of that skill through these high fees. The industry is currently facing a liquidity crisis. Funds are struggling to sell their holdings at a normal pace, leading to "creative" accounting. Managers are increasingly using "continuation funds" or "evergreen funds," where they essentially sell assets to another fund they also manage. This creates a massive conflict of interest; if a manager cannot find an external buyer, they may be offloading a "lemon" onto their own evergreen fund investors at an untested valuation. Furthermore, "NAV squeezing" has emerged as a major red flag. Institutions like Harvard and Yale have been forced to sell PE stakes at discounts of around 11% to free up cash. Interestingly, the secondary buyers can purchase these stakes at a discount but immediately mark them back up to the original Net Asset Value (NAV) on their books, creating an immediate, yet purely "paper," return. ### The Risks in Private Credit Private credit—loans made to private companies by non-bank entities—has exploded in popularity. Like PE, it is marketed as a high-yield, low-volatility alternative to bonds. However, Felix notes that when these loans are properly benchmarked, there is no evidence of a "special" premium. The danger in private credit is currently manifesting through "gated" redemptions. When investors get nervous and ask for their money back, funds are often forced to lock their doors because the underlying loans are too illquid to sell. Felix contrasts this with publicly traded Business Development Companies (BDCs). When the underlying loans in a public BDC sour, the share price drops immediately, providing honest price discovery. In contrast, unlisted private credit funds hide this volatility until they are forced to stop redemptions entirely, leaving investors stuck paying fees on "stinky" assets they cannot sell. Felix also highlights a "closed loop" of risk involving insurance companies. PE firms are buying life insurance companies and replacing their conservative portfolios with private credit funds managed by the same PE firm. This creates a dangerous concentration of risk that could have severe repercussions if those private loans fail. ### The Illusions of Private Real Estate Private real estate funds, which own physical assets like office towers and malls, are also facing a liquidity crunch, particularly in Canada. As public Real Estate Investment Trusts (REITs) have taken a beating, private fund managers have gated their funds to avoid selling assets at a loss. Some of these funds are now attempting to go public to provide liquidity. However, recent examples in the US show that when these funds hit the public market, the "paper" NAV often collapses. Felix cites instances where funds with a stated NAV of roughly $18 or $24 saw their share prices drop by 30% to 40% on their first day of public trading. The risk was always there; the private structure simply prevented investors from seeing it. Research from 2018 and 2019 confirms that private real estate returns are fully explained by the same factors that drive public REITs, meaning there is no unique "private" advantage. ### Conclusion Ben Felix’s conclusion is clear: private markets do not offer a "free lunch." The perceived benefits of high returns and low volatility are largely products of high fees, infrequent valuations, and illiquidity. For the average investor, the trade-off is often unfavorable. While public markets are volatile, they offer the essential benefit of liquidity and honest price discovery. Felix advises retail investors to remain skeptical of the sales pitches and to recognize that "protecting" oneself from volatility by moving into private assets often means simply losing the ability to access one's money when it is needed most.