Why innovative ‘liquid’ private market investments may not always run smoothly

Private markets are an increasingly important consideration when it comes to building a diversified investment portfolio. Institutional investors such as pension funds, endowments foundations and family offices have known their value for years. Now, spurred by growing awareness of underlying strategies such as private equity and volatility in global public markets, an increasing number of private investors want a piece of the action.  

Private capital is also becoming a very attractive market for fund managers, which is no surprise. Estimates suggest total global wealth held by individuals is $450 trillion¹, and with less than 5% of the portfolios of the wealthiest segments² currently allocated to private market alternative investments,  the growth opportunity is clear. Additionally, with private equity exits suppressed in recent years and, consequently, fundraising from traditional institutional markets taking a hit – fund managers are increasingly happy to target individual investors and the wealth channel. 

In order to overcome one of the main historic barriers to this audience of investing in private markets, that of liquidity, managers are creating new ways to provide access. For example, semi-liquid ‘evergreen’ private equity funds and blended public/private market funds promise to allow investors to redeem their capital on demand.  

While innovation to open up private markets to a wider audience is, in many respects, to be welcomed, it’s vital that investors fully understand the risks and the dynamics of what they are investing in, particularly when it comes to models that offer instant liquidity. There are legitimate concerns that this may often not be the case. 

Opening up more access routes for private capital  

When considering allocating to private markets, there are some fundamental points for investors to take into account. Firstly, assets such as private equity investments should make up only a small proportion of their overall portfolio. Secondly, they must be comfortable with the higher level of risk that comes with investing in assets that offer higher returns potential. And thirdly, in order to realise what’s known as the ‘illiquidity premium’ – the opportunity to generate outsize returns by investing for the long term, e.g. by backing companies as they grow and create value over time - their capital will need to be committed for at least several years. 

For investors with the right experience to appreciate the risks and rewards and sufficient personal liquidity to make such decisions appropriate, the main way to access this arena up until now has been through innovative models like ours, which pools private capital committed by investors in £25k units, and enables them to invest into top-tier institutional funds or direct single asset transactions.  

Today, other routes are emerging, as global fund managers start to offer their own wealth channel models to make it easy for private capital to embrace private market investments. That more private investors should be empowered to access such an important asset class is another step in the right direction – after all, that’s exactly what we founded Connection Capital to do 15 years ago. Yet, we would argue that some of these new models pose risks that private investors might not anticipate, and could cause conflicts of interest to arise. 

The rise of semi-liquid evergreen funds – is it all plain sailing?

Take the rise of semi-liquid ‘evergreen’ funds. Unlike traditional, closed-ended private equity funds in which investors commit their capital for a five-ten year timeframe, these vehicles are open-ended, meaning that in theory investors can enjoy liquidity by withdrawing their investment whenever they choose.  

That’s an appealing proposition, so no wonder they are proving popular. Taking the US as a bellwether, according to Morgan Stanley there were more than 350 semi-liquid evergreen funds in the US in Q3 2024 with net assets under management of over $380 billion, and more than half those were launched within the last four years³. Yet, for all the buzz, there are several drawbacks to consider here, including: 

The liquidity mismatch  

The concept of providing liquidity for funds that hold illiquid assets (i.e. those that are acquired with a long-term hold period in mind and that can’t be sold quickly) poses a major problem, in that there’s an inherent liquidity mismatch. Inflows and outflows in these vehicles are volatile, and if everyone decides they want in or out at the same time, that creates serious challenges for fund managers, either when it comes to deploying capital quickly – or worse – when it comes to returning it if redemption requests are made en masse.  

There have been several stark examples of the latter in recent years, typically when investors are responding to some kind of dislocation. When investors in open-ended property funds rushed for the exit at once after Brexit, they soon found that they couldn’t have their money back because it was all invested in assets that couldn’t (and shouldn’t) be sold in a hurry. Many investors in the open-ended Woodford Equity Income Fund failed to get their capital out before its collapse because it had high allocations to illiquid stocks, with the FCA criticising the manager for having “a defective understanding” of the liquidity risks of its approach⁴.  

The painful lesson is that, when there’s a stampede to get capital out, these funds might prove not to be liquid at all. 

Inflated valuations, fee conflicts and cash ‘drag’

Traditional closed-ended funds are designed to deploy capital committed incrementally over the life of the fund, whereas in evergreen structures new investors are continually committing and withdrawing capital. Therefore, there is intense pressure to put as much capital as possible to work straight away, as performance is under scrutiny at all times. That can create a lack of discipline around how much managers are prepared to pay for assets. Indeed, research by advisory firm Campbell Lutyens found that evergreen vehicles paid 4% more last year on average for stakes in secondaries funds than traditional buyers⁵.  

Another issue is that in semi-liquid vehicles, if an asset is acquired at a discount to net asset value (NAV), it is common practice to mark valuations back up immediately afterwards, to reflect the ‘true’ market value. Fees are then based on net asset value (‘NAV’), even though this includes unrealised value. The FCA’s recent review of private market asset valuations highlighted that there is the potential for conflicts of interest to occur when fees are charged on a NAV basis.6 By contrast, there is little incentive to inflate valuations in a closed-ended structure as management fees are typically charged on capital committed and carry only paid when assets are finally sold, and their actual value has been realised.  

Further conflicts can arise when exiting assets. In a closed-ended fund, the structure ensures that assets are disposed of in a way that maximises returns within the fund’s lifetime. But in an evergreen structure, the fact that fees are being charged on NAV on an ongoing basis could act as a disincentive to sell the assets, which may not be in investors’ best interests.  

Moreover, if liquidity is being offered by a fund that holds illiquid assets, then it will be necessary to keep a high enough level of cash in the vehicle to meet ad hoc redemption requests. That will inevitably create a drag on returns, undermining investors’ ability to achieve the higher returns multiples that private equity investments are capable of generating. 

Hybrid public/private funds - a better liquidity balance?

One solution to having to hold substantial amounts of cash could come in the form of hybrid public/private markets funds which are now starting to come onto the market. The liquidity provided by the public market investments should, so the thinking goes, be sufficient to meet investors’ liquidity needs, while allowing them to diversify their portfolios in a single fund.  

However, the reality is more complex than it may first appear in this case too. For one thing, investing in illiquid private market assets such as private equity deals that take time to mature and execute their value creation plan requires a totally different skillset on the part of fund managers than investing in tradeable public equities that can be subject to extreme volatility. Whether this is a workable mix is debateable. 

For another, if public market dislocation triggers high demand for redemptions and fund managers are forced to sell their liquid assets quickly, the fact that they are likely to be selling in a sub-optimal market is not the only downside. There’s also the denominator effect to consider. 

This is where the balance between the funds’ public and private holdings gets out of kilter. Suddenly fund managers find themselves with weightings that are too high in private markets and too low in public equities, and quickly have to try to recalibrate. If that happens, they might either have to pause their private market investment programmes, and potentially miss out on good opportunities that had been lined up. Or they may even have to look at selling private assets that are performing well at a significant discount as a ‘motivated seller’. Even then, deals will take time to complete, which brings us back to the illiquidity issue.  

Approach with caution 

Innovative solutions that democratise access to private markets are no bad thing – provided a pragmatic, responsible approach is taken to meeting investors’ needs and protecting their interests. While semi-liquid evergreen private equity structures are tempting, history tells us that actually delivering the promised liquidity when the underlying fund assets are illiquid is fraught with challenges. Whether public/private hybrid funds are a better solution remains to be seen. 

As with any kind of investment  - but particularly so in this case - investors must realise the nature of what they are investing in, and bear in mind the potential downsides as well as upsides. Experienced private investors should be in a good position to make well-informed judgement calls, but less sophisticated retail investors may not. With that in mind, both investors, wealth managers and the fund managers considering going down this path should approach with caution. 

Sources:

1. UBS: https://www.ubs.com/global/en/wealthmanagement/insights/global-wealth-report.html
2. The Investment Association: https://www.theia.org/sites/default/files/2021-12/IA_Goji_WhitePaper_PrivateAssetsinWealthPortfolios_Dec2021.pdf
3. Institutional Asset Manager: https://www.theia.org/sites/default/files/2021-12/IA_Goji_WhitePaper_PrivateAssetsinWealthPortfolios_Dec2021.pdf
4. The Guardian: https://www.theguardian.com/business/2024/apr/11/financial-conduct-authority-warning-neil-woodford-fund-collapse
5. Financial Times: https://www.ft.com/content/8179cfdf-e31a-4484-8442-23a61815d5eb
6. Citywire: https://citywire.com/wealth-manager/news/fca-spells-out-numerous-private-markets-valuation-conflicts/a2460970