The Problem with Private Markets | Rational Reminder 402

0:08 This is the Rational Reminder podcast, a weekly reality check on sensible

0:11 investing and financial decision-making from three Canadians.

0:14 We're hosted by me, Benjamin Felix, chief investment officer, Dan Bordalotti,

0:17 portfolio manager, and Ben Wilson, head of M&A at PWL Capital.

0:23 Yeah, awesome.

0:23 It's good to be back.

0:24 This is episode 402 where we're talking about

0:27 the talking about private markets or the problems with private

0:31 markets which is a a pretty interesting topic and it

0:34 has been a hot topic in news headlines recently.

0:38 Yeah, it's good to be back recording with you guys.

0:40 We haven't recorded an episode like this in in quite a while.

0:43 We had a a long string of of guest episodes.

0:46 Uh so yeah, good to be good to be back.

0:49 Good to be here.

0:51 Yeah.

0:52 Uh before we jump into the private markets content,

0:55 I I did want to just address something.

0:56 I've had a couple conversations recently where people had no idea what PWL does,

1:02 which to us is a little bit concerning because we do expend a lot

1:05 of energy creating content and and uh just putting ourselves in the public

1:09 eye so that people know who we are and uh know to reach

1:12 out to us if they're looking for the services that we provide.

1:16 Uh and so when people don't know what we do, it's kind of like, oh,

1:19 we should we should probably make sure people know what it is that we do.

1:22 In both of these cases,

1:24 uh these people thought that PWL only does asset management and they'd

1:28 kind of written us written us off as an option for what

1:30 they were looking for, which was more of a a holistic wealth

1:33 management type service uh because they thought we only did asset management.

1:37 So I I just wanted to mention upfront here that PWL is a wealth management firm.

1:42 We do manage investment portfolios using

1:44 lowcost index funds and dimensional funds.

1:47 But as discretionary portfolio managers,

1:49 we look at the client's full financial picture

1:52 and their long-term plan in the course of giving investment advice.

1:55 And that includes running financial planning projections,

1:58 considering how the investment advice we're giving

2:00 integrates with the other major financial planning areas.

2:03 And then the other thing is that since we're managing

2:05 the investments which connect to really everything else in someone's life,

2:09 we do generally end up sitting in the middle of the client's

2:11 financial situation coordinating between other

2:13 professionals like lawyers and accountants.

2:16 And so that really us sitting in the middle there

2:18 really ends up taking a lot of the mental load

2:20 off of uh of the client who instead of them

2:23 having to be central to everything that's happening and coordinating everything,

2:26 we're able to take a lot of that on.

2:29 Yeah, exactly.

2:30 It's it's a truly like end to end wealth

2:33 management offering because we need to know about everything

2:37 that is going on in a financial in the financial

2:39 lives of our clients to give good quality advice.

2:44 Yeah, exactly.

2:45 Yeah.

2:46 It's very difficult to make investment decisions

2:49 for a client without understanding all of those things.

2:51 And yet, you know, we know from others

2:53 in the industry and talking to new clients, for example,

2:57 that it's pretty common for people to get investment

3:01 advice that's almost completely separated from their personal situation.

3:06 Uh it this the sort of um comprehensive way that we do it,

3:11 integrating the investment management with the planning,

3:14 it's becoming a more popular model of course,

3:16 but it's certainly a much better one for uh uh for the client.

3:21 Yeah, I think so.

3:22 And that's kind of we we've always firmly held

3:24 this belief that to give the best quality investment advice,

3:27 we really need to have that that full end

3:30 to-end picture that goes right through to the estate plan.

3:32 Um otherwise, you just like that the estate plan just using

3:35 that as one of the examples that does interact with asset

3:38 allocation uh and even when you should buy and sell uh

3:42 different securities in in the course of uh of of investment planning.

3:46 So it's anyway all that to say we are a wealth management firm.

3:49 Uh and we we do look at the full financial picture not just the portfolio.

3:56 Uh all right jump into our main topic.

3:59 Let's do it.

4:03 Okay.

4:04 So, I do want to preface this by saying

4:06 that after I released my video on this topic,

4:09 which is a few weeks ago, uh, when this episode gets released,

4:12 Larry Swedro, who we all have lots of respect for, pushed back pretty

4:16 hard on several of the points that I made in the RR community.

4:19 Um, I I think we ended up having a pretty good back and forth discussion,

4:22 which is still ongoing at at the time that we're recording.

4:26 Um but I'll relay the main points that Larry made and my responses

4:31 which I also made in the community after I've gone through the topic.

4:36 Uh so after many years of hiding behind sort of a mystique uh and ill liquidity,

4:45 private markets are really being forced into the light recently.

4:47 There's been a ton of a ton of media coverage

4:49 of of some of the things that are happening in private markets.

4:53 uh private equity, private credit and private real estate infrastructure too,

4:56 but I'm not going to address that uh in this in this discussion.

5:01 But private assets in general have been sold super hard to investors on the pro

5:06 on the premise that they offer higher

5:08 returns with less risk compared to public markets.

5:14 As fund managers push for these investments

5:16 to become more accessible to retail investors,

5:19 which is another big thing that's happening right now,

5:21 I think there's a lot of caution warranted.

5:24 I've always been skeptical of private assets.

5:27 Uh I I think my skepticism is being validated in kind of real time here.

5:32 2026 has been a wakeup call for everyone

5:35 who was convinced that private assets were special.

5:39 Uh that private markets are really having a a bad time right now.

5:42 Uh some private equity funds are having trouble selling their holdings,

5:46 often resorting to selling private company shares

5:49 or uh private equity fund stakes to themselves.

5:54 Uh which is a pretty interesting concept.

5:58 Um well, we'll talk more about that in a minute.

6:01 Some private real estate funds can't sell their underlying holdings

6:04 to meet investors demands for liquidity and are having to gate,

6:08 which is kind of industry lingo for for locking up the funds,

6:11 telling investors they can't have their their money back.

6:14 And private credit funds, many of which are also gating redemptions,

6:18 are realizing that a lot of the loans they've made might have been pretty risky.

6:22 And I think they kind of knew that, but um I think investors are realizing,

6:26 oh, the these loans were were quite risky.

6:30 uh which has not been apparent because in many cases the private

6:34 credit funds uh because they're not marking the assets to market value.

6:39 They look very stable.

6:41 But um that's been changing in recent history.

6:45 Personally, I've not been too surprised to see any of this.

6:47 It's kind of like okay, this is this is finally happening.

6:50 Uh long time coming.

6:51 Uh but I think a lot of investors in private markets will

6:54 be surprised just because of the way that this stuff has been sold.

6:58 Uh again, fund managers have pushed private market

7:02 investments really relentlessly on this premise that private

7:06 market investing offers lower volatility and higher expected

7:09 returns than what can be found in public markets.

7:13 That's a compelling sales pitch, but to me it just never it never smelled right.

7:19 Uh so in the rest of this discussion,

7:22 we're going to discuss each of the major private asset classes,

7:25 private equity, private credit, and private real estate.

7:27 As I mentioned before, we're going to leave infrastructure out.

7:29 That's a different topic for for another day.

7:32 Uh but we'll review what the evidence says

7:35 and what is happening in each asset class right now.

7:38 I think I think to go back to your sales pitch comment,

7:43 I I think that's important because the reality is that most

7:47 of these private market products are so complex that the average

7:51 investor and could even go as far as saying even

7:55 a lot of advisers don't fully understand the intricacies of each product.

7:59 But the way they are pitched sounds like an attractive,

8:04 lower volatility, lower risk, not very correlated to the public market.

8:10 So it sounds really sexy and like of course I want that.

8:13 I can get better returns with less risk,

8:16 then why wouldn't I add that into my portfolio?

8:18 So it's attractive to the investor, but you have to actually dive deep to fully

8:23 understand to see what you're getting yourself into.

8:26 Yeah.

8:27 And to your point, Ben,

8:28 I think we we did an episode with with my friend Aravind.

8:31 I think that was last year.

8:33 Was that that last year?

8:34 Earlier this year, I don't remember.

8:36 Uh anyway, uh last year, yeah,

8:39 December of last year, uh we did that episode titled,

8:42 "Is anyone doing due diligence?" It was basically like these products are

8:46 super complex and even a lot of advisers are probably not doing

8:50 the level of due diligence that that uh maybe would ideally be

8:55 done on these products because it's hard because they are so complex.

8:59 There may be a um an attraction here though

9:02 in that superficially I guess they don't seem complex like I think

9:06 on the surface investors understand okay you're investing in businesses

9:10 that are not publicly traded or you're investing in real estate.

9:14 we all understand what those are.

9:15 You're making loans to you know businesses

9:18 or individuals who are not getting conventional financing whatever.

9:23 So on that level, compared to something like, you know,

9:27 covered calls and leveraged ETFs and all

9:29 these things that are on their surface complex,

9:33 um these may lull people into an idea that they're kind of common sense,

9:38 straightforward investments,

9:40 and they don't realize how the products are structured, how the funds are,

9:44 um what kind of restrictions they might have on them.

9:48 So yeah, I mean I think the complexity might not scare

9:52 people off until they start to scratch the surface a bit.

9:55 Yeah, that's a good point.

9:56 The the narratives are simple, but the products are complex.

10:01 Um, okay.

10:02 So, private assets are just assets like stocks,

10:07 equity holdings, and companies, loans made to companies, uh,

10:10 infrastructure assets, which I mentioned we're not going to go into much detail,

10:14 and real estate assets.

10:15 Uh, so they're just assets that have not been listed on a public exchange.

10:19 Now, this means that you can't log into your brokerage account

10:22 and trade private assets like you can trade publicly listed assets.

10:26 And it also means that the underlying

10:27 company's disclosure requirements are not as strict.

10:30 The filing requirements to be publicly listed are are very stringent.

10:35 You just don't have that as a as a private company.

10:38 Since they don't trade on public exchanges,

10:40 the prices of private assets are not being set throughout

10:43 the day like what we see with publicly listed stocks,

10:45 bonds, and REITs, which makes them appear less volatile.

10:49 Now, appear is the the key operator there.

10:52 Uh, as we'll talk about, I I think they probably are at least

10:56 as volatile as public equities uh under the hood.

10:59 Like the the economic fundamentals,

11:01 if the assets were markettomarket, they're no less risky.

11:05 they just show up that way on paper.

11:09 Uh for it would actually feel less risky to a client too.

11:12 Like if you don't see the fluctuation

11:14 like from an investor behavior perspective,

11:17 ignoring the complexity for a minute, that piece is actually a positive,

11:22 but it's really uncertainty or like ambiguity in the actual

11:28 price because you don't know what it is.

11:30 Whereas public market, you could see it jump two or three or 4% in a day,

11:35 which is is stressful to see.

11:37 This could be happening behind the scenes without actually realizing it.

11:40 Correct.

11:41 Which is a concept that Auntie Elman when he was

11:43 on this podcast a long time ago, not that long ago.

11:46 It was like episode 200 and something.

11:48 Uh he referred to this as smoothing as a service,

11:51 which is like or cliff as called volatility laundering.

11:55 The volatility is still there.

11:56 you just don't see it, which may be appealing to some people,

11:59 which has implications for asset prices, which we'll talk about uh in a bit.

12:04 Um, so for for a long time, private market investments were largely contained

12:08 within the realm of institutional investors,

12:10 entities like university endowments, pension funds,

12:12 and not for-profit reserve funds.

12:15 These are entities with lots of capital,

12:16 extremely long time horizons, and often professional staff.

12:21 I would argue and I have argued in in a past video that uh

12:25 with supporting evidence that private markets are

12:28 even questionable for those types of investors,

12:31 but more recently private assets have

12:33 been increasingly pushed onto retail investors.

12:36 Uh whether they're asking for them or not,

12:38 they've really been sort of shoved down people's throats.

12:42 Excuse the expression.

12:44 Uh, now I know in my job as CIO of PWL,

12:48 I see these sales pitches all the time and they only seem to be increasing.

12:52 Well, we know they're only increasing.

12:54 The the Ontario Securities Market Regulator, uh,

12:56 the OSC is being pressured to authorize a new class of mutual

13:01 funds that can hold higher risk private assets aimed at retail investors.

13:04 And similar things are happening in the US

13:06 targeting the retirement accounts of 401 of uh,

13:08 of American families.

13:09 That's the 401k.

13:11 Getting private assets into 401ks.

13:14 Even if you could convince me

13:16 that institutions should be investing in private assets,

13:19 which you know that I don't know if you

13:22 can convince me of that, but if you could,

13:24 I think the case for retail investors is even harder to make.

13:27 Uh, as we talked about a minute ago, the underlying assets are illquid.

13:31 The fees are high and complex.

13:34 uh and the agreements governing how fees work,

13:37 how liquidity works and just how how the whole

13:39 the whole uh structure works is is complex.

13:43 It's not easy to understand.

13:46 The issue I think is that there's

13:48 a huge incentive to convince retail investors otherwise.

13:53 Retail investors in aggregate have a a lot

13:55 of money and the fees charged by private

13:58 market fund managers make them make these products

14:01 very attractive for the financial institutions selling them.

14:04 This is particularly true in a world

14:06 where investors are increasingly adopting lowcost

14:08 index funds for the public market investments

14:11 driving down profit margins for financial firms.

14:13 And it's even beyond that actually.

14:15 It's index funds are driving down asset management fees period.

14:19 It's the the Vanguard effect which we talked about uh

14:22 in a in episode 400 or I don't know if we talked about

14:27 it directly but it was at least alluded to that index funds

14:30 have driven down fees for index funds but also for active management.

14:35 So the margins in asset management are getting smaller which makes

14:38 a higher margin product like like private markets really really attractive.

14:44 And then another issue that's particularly cynical

14:49 is that retail investors are a huge potential

14:52 source of liquidity for anyone currently invested

14:55 in private markets who wants to get out.

14:57 Now, that liquidity has been a big problem for private markets lately.

15:00 We'll get more into that later, but this leads to the potential for adverse

15:04 selection where retail investors who are like,

15:07 you know, oh, we're going to democratize private assets.

15:09 Come on, retail investors, get on in here.

15:12 But retail ends up getting saddled with the illlquid stuff that nobody

15:15 else wanted to hold that couldn't be sold to somebody else.

15:19 So all this retail money comes in and that's

15:21 who gets to buy those non-desirable assets.

15:25 Um yeah all this is happening these private assets getting pushed onto retail.

15:32 There's a debate going on whether that's a good thing or not.

15:35 And then in real time right now,

15:37 the current investors in these funds have been kind of forced

15:41 to learn that their private market investments are pretty risky,

15:44 riskier than they appeared based on their paper volatility.

15:50 Any comments from you guys before I keep going?

15:56 I yeah I mean I I I'm interested

16:00 in your in your point about retail investors getting saddled

16:04 with you know uh sort of bearing the brunt

16:08 of the illquidity burden that um institutional investors should otherwise carry.

16:14 Um I I think that there are other precedents for this as well.

16:18 This idea that individuals can invest

16:22 like institutions in theory it sounds great.

16:25 It sounds like opportunities to diversify beyond uh

16:29 investments that have traditionally been available to retail investors.

16:33 But once you add one or two middlemen, any advantage uh is lost, right?

16:40 I mean, like you said, you could probably convince me that institutions should

16:45 include private assets as part of their portfolios.

16:48 If they're managing tens of billions of dollars,

16:51 you can maybe make a compelling argument.

16:54 It's not that great of an argument,

16:55 but I I can at least accept that you could present one.

17:01 For the average retail investor,

17:02 what the global stock market is not diversified enough for you?

17:06 Like, it's just really unconvincing.

17:09 and what do you think you're going to be left with after the institutions

17:13 have chosen the assets that are you know have the best risk return trade-off.

17:19 So there's a bit of naivity I think in there.

17:22 Yeah, I think that the adverse selection piece is is really is really important.

17:26 Um and the liquidity thing is like

17:28 usually private equity funds just using private equity

17:32 as the example they want to turn over

17:34 their holdings whatever it is every three five seven whatever

17:38 uh whatever it is years they they want

17:39 to sell the underlying private companies and return

17:42 that capital to investors but that has been uh

17:45 becoming increasingly difficult like a lot of these private

17:48 equity funds are not able to sell

17:50 their holdings right now and they have not been

17:51 able to sell them for a bit so they're accumulating this big log jam as one

17:56 article that I read called it of of unsold

17:58 private company shares which like in order

18:02 for the current investors in those funds to get

18:04 liquidity there needs to be new new buyers.

18:07 Somebody has to buy this stuff but they're

18:09 not able to sell the companies for a reason.

18:13 Uh so that's that's just the adverse selection concept

18:15 which I think is is worth keeping in mind.

18:18 Um so recently we have seen private funds write down the value of their assets

18:22 and we've seen them tell investors they can't have their money back right now.

18:25 That's the concept of gating that I talked about earlier,

18:28 which is happening more and more.

18:31 Uh, and it's, you know, it's not great.

18:34 Uh, if you're an investor in a fund

18:35 and you decide you want to sell and they say,

18:38 "Nope, sorry, can't have your money back." That's, you know, that's not fun.

18:43 Uh, we've actually also seen

18:45 there's also usually pretty uncertain time periods when the gating happens.

18:48 It's like, yes, it's locked up, but it's not always like,

18:51 okay, in two months you'll be able to redeem.

18:54 It's we got to figure some things out and we hope to open it back up,

18:59 but it's not always certain and there's different

19:01 outcomes that can can happen depending on the situation.

19:05 Yeah.

19:05 And we've had to deal with this at PWL.

19:07 In some cases, we have uh inherited from in various ways, private private funds.

19:14 And we've had to deal with this uh and it's yeah, it's not fun.

19:18 And not not just recently, like there have been other historical examples other

19:22 than uh other than what we're seeing now.

19:24 And and uh we've had to deal with okay,

19:27 we have this asset that we can't sell or we

19:29 have a window every quarter where we can sell some.

19:32 And it's just it's not a good it's not a good experience.

19:36 And usually when a fund gets gated or locked up,

19:38 it's it's because the underlying assets are not performing well.

19:41 So it's uh it's just not great.

19:44 Uh the other interesting thing that's happened is we've seen

19:46 some of the biggest historical proponents of private market investing,

19:49 which are IV league endowments,

19:51 uh they've started to dial back their exposure a little bit.

19:54 There was an article that I read on that.

19:57 Uh they've also started to lower their expected returns

19:59 for their private market allocations a little bit which is also interesting.

20:02 Um there are some large wealth management firms in Canada that have been

20:07 pretty aggressive about promoting their private

20:09 market funds and and just private market

20:11 investing more generally while also being

20:14 quite vocal criticizing the traditional 60/40 stock

20:17 bond portfolio calling you know the the 60/40 portfolio is dead yet yet again.

20:22 Uh but those same firms now have had to write down the value

20:26 of some of their private funds by pretty significant amounts, you know.

20:30 So you got this like years of stability and kind of up to the right stability

20:34 and then this one boom drop because I

20:37 mean hey there there was volatility in the interm.

20:40 It's just they they they waited until they had

20:43 to I guess to to mark down the values.

20:45 I don't know, but it really shows that uh the the smooth up to the right

20:50 chart was not real uh for lack of a better way of of saying that.

20:56 Um and the the other that that same firm and I

20:59 I don't want to I don't want to name them necessarily,

21:01 but uh they've just been very vocal

21:04 about this type of investing and basically implicitly

21:07 saying that the way PWL manages assets is

21:09 insufficient because we're not doing private market investing.

21:12 Um, so they've had to they've had to write down the value

21:15 of of one of their funds significantly and they've had a bunch

21:18 of their funds gated where they're again they're having to tell investors

21:21 that you can't access your money right

21:23 now because the underlying assets are illquid.

21:27 I think I think this Yeah, sorry Ben.

21:29 I was just going to say I think like the illquidity

21:32 side of this is so important for retail investors, right?

21:36 Like it's one thing if you're an institutional investor

21:40 and this is a small part of your portfolio and you've

21:42 got lots of other liquid assets and you maybe don't

21:46 need a lot of money in any given year whatever

21:48 it is but with a retail investor like look

21:51 your needs change from time to time and look I've even

21:55 seen it working with clients like buying GIC's that we

21:59 ended up regretting now GIC's are illquid I get it.

22:04 Yeah.

22:04 The thing is though, you kind of you know when they're going to be

22:06 redeemed and you know exactly what your return is

22:09 going to be and you accept the illquidity because you

22:12 get a little higher return compared with a similar investment,

22:17 but you don't put somebody in a sign like you have to really

22:21 limit the number of GIC's that you're going to use for a client.

22:25 And if you're going to hold them,

22:26 you're going to hold them in a retirement account for a younger

22:29 person or something where you know you're not going to need the money.

22:31 I guess my point is you better be expecting

22:34 a very very high premium compared with a liquid investment.

22:39 If you're going in and I don't know what that premium is,

22:42 but I'm thinking it for me if it's not double

22:45 what I would expect from an equity like liquid investment.

22:49 I'm not interested because the cost is just the illquidity cost is too high

22:56 for people who don't always know what

23:00 their future liabilities are going to be, right?

23:05 Yeah.

23:04 Um so yeah, to me the nightmare is you put a significant

23:08 amount of your savings into a fund like this and it gets gated, right?

23:12 Yeah.

23:12 Uh, look, I have a couple legacy holdings that have come over with clients

23:16 from many years ago that we still have that we can't get out of.

23:19 They have now rolled into riffs.

23:22 Like some at some point that money is going to come out and we can't get it out.

23:26 So, you know, I I just the ili liquidity

23:30 is really to me what what scares me the most.

23:32 If you could price these things every day and you could

23:36 get out of them even with monthly or quarterly liquidity, then maybe.

23:40 But of course the argument is the reason that you can

23:43 expect higher returns is because

23:46 of the illquidity and these other characteristics.

23:49 But it it doesn't become a very compelling argument to me at some point.

23:55 Yeah.

23:56 No, I agree.

23:57 And that's that's one of the big questions is is there and this is

24:01 one of the things that Larry and I went back and forth on.

24:03 Is there an illquidity premium?

24:05 because the two competing forces there are what what you just said Dan that you

24:10 you better expect compensation for taking

24:13 on that ill liquidity but then the the competing

24:16 force is smoothing as a service where people may be willing to overpay

24:20 for private assets despite the illquidity because

24:23 it's going to make investment returns look smoother.

24:26 So from our seat like if we're financial uh

24:29 if we're portfolio managers as we are and we're worried

24:32 about our clients panicking in a down market or we're

24:34 worried about our performance relative to a public markets benchmark,

24:38 we might have a big incentive to include private

24:41 assets because of the way that they affect paper returns.

24:45 So yeah, there's ili liquidity, but if we can say, "Hey client,

24:47 you know, your portfolio is not not down as much as the market.

24:50 How great is that?" We may be willing to pay more for that.

24:55 Yeah.

24:55 And I accept that as a potential appeal, right?

24:59 I mean, I do think that investments that are not markettomarket every day,

25:04 this illusion of no volatility has some value for anxious investors.

25:11 It it's just how far do you want to push that point, right?

25:15 I mean, if it truly is an illusion,

25:17 like if it is a volatile asset and you just don't think it is,

25:21 then at some point that's probably going to break.

25:24 Yeah.

25:24 Yeah.

25:24 So, that's another point Larry and I went back and forth on.

25:26 I'll get to that in a minute.

25:27 This what we're talking about is like one

25:29 of the inherent trade-offs in in private markets.

25:32 You do get less reported volatility

25:34 because the underlying assets are valued infrequently,

25:37 but you might be denied access to your money

25:40 if the private fund doesn't want to be

25:42 forced to sell its underlying illquid assets when

25:44 you need access to your money, which is fine.

25:47 That's not private funds being evil.

25:48 That's private funds doing exactly what they're supposed to do.

25:51 they shouldn't be forced to give you your money back because you signed

25:54 up for an illquid investment and to manage their private asset portfolio well.

25:59 They cannot be forced to go into these fire sale scenarios.

26:02 So from the funds perspective, it makes sense.

26:04 Um from the investor's perspective, it's a trade-off that has to be considered.

26:08 In public markets, you can pretty easily sell any time,

26:12 but you're subject to market prices.

26:15 So, I think an interesting question to consider is whether it is

26:18 worse to live with volatility but always have access to your money even

26:22 if your investment has declined in value or to be artificially shielded

26:26 from volatility while potentially being denied the option to sell at a loss.

26:31 Like if your investment's down a bunch, you probably don't want to sell,

26:35 but it's kind of nice to know that you could.

26:37 Whereas with a private fund, it's like, "No, no,

26:40 look, the the the net asset value hasn't changed.

26:42 We're good.

26:42 Everything's fine." But no, no, no.

26:43 You can't have your money, though.

26:44 No, no, no.

26:46 Yeah.

26:46 I Which one's worse?

26:47 I I I don't know.

26:47 I don't know if there's like a universal answer.

26:50 And maybe the answer is having a little bit of uh of both.

26:54 A little bit of volatility and a little bit of illquid smoothing.

26:56 I don't know.

26:57 Personally, and for PWS clients,

27:00 I generally prefer liquidity and knowing what the assets are worth every day.

27:06 That that timeline uncertainty I keep coming back to.

27:08 I think that that's important though cuz like if you knew

27:12 it's going to be like the GIC example Dan brought up,

27:15 there's a fixed period, fixed term,

27:17 you can accept that ili liquidity for an expected premium.

27:21 But with these private assets, it could be ili liquidity followed by oh,

27:28 there's actually no value and the fund had to collapse.

27:30 Yeah.

27:31 Yeah.

27:31 Yeah.

27:32 So you may never get asset value from it.

27:35 Maybe you will, but maybe you won't.

27:38 Yeah, that's a very good point.

27:40 I think I mentioned that later about just

27:42 how like when your fund gets locked up,

27:44 you're kind of forced to own assets that you

27:46 know are distressed and you don't know what the outcome

27:49 is going to be and yeah and you're going

27:51 to continue paying private asset private fund level fees.

27:54 Anyway, uh I I think that the kind of inflection point where these things

27:59 started gaining a lot of popularity popular

28:01 popularity was following the 2008 financial crisis.

28:04 um likely at least in part in response to the traumatic

28:08 levels of volatility in publicly listed assets over that period

28:12 and also the need for investors to find ways

28:14 to recover from the losses they sustained in that market decline.

28:17 Like if you're an institution in '08,

28:19 all of a sudden your assets have tanked in value.

28:23 Your liabilities, if you're a pension fund or an insurance company,

28:27 liabilities haven't changed uh necessarily.

28:31 And so you've got this big shortfall all of a sudden.

28:33 And so a lot of institutions started looking

28:36 at how can we get how can we not live

28:38 through this crazy volatility again and how can we

28:40 increase our expected returns to make up our current shortfall.

28:44 Private markets were sold as a less

28:46 volatile place to invest with potentially higher returns,

28:51 higher expected returns.

28:53 In my opinion, that alone should be a major red flag,

28:58 the promise of uh lower volatility and higher expected returns.

29:01 But people really want to believe that they are

29:04 not subject to the economics of risk and expected return.

29:07 People people want to want to believe they can find a free a free lunch.

29:12 Um another interesting point here is that a big

29:14 selling point just on the topic of institutions,

29:17 a big selling point always was and continues to be Yale's endowment.

29:22 Yale kind of pioneered the strategy of going

29:25 into illlquid private investments and they did earn

29:29 years of famously high returns investing in private

29:32 markets with the legendary David Swenson at the helm.

29:35 Other investors have always wanted to kind of emulate that outcome.

29:39 Now there's been some recent research that's quite interesting.

29:42 Basically showing that while Yale did perform well,

29:46 um the kind of the idea that they

29:48 earned 30% annualized returns in private markets,

29:50 which is a number get that gets thrown

29:52 around uh was was probably not what happened.

29:55 Uh those 30% per year returns over over a pretty long period of time were based

30:00 on IRRs which can be very very misleading

30:05 particularly when uh early returns are are high.

30:08 So when when you look at Yale's returns, they're much lower.

30:13 Anyway, it's just a an interesting point.

30:15 My view on private assets has always

30:17 been that net of fees and properly benchmarked,

30:20 there's nothing special in private assets.

30:25 That can be contentious and we'll we'll talk more about that.

30:29 Um, but I think that that point only gets more true

30:33 in the realm of retail investors who generally pay even higher fees.

30:38 And adding on to that the issues

30:40 of adverse selection that we've we've already talked about.

30:42 Now again, this can be contentious like

30:44 do do private markets outperform public markets?

30:47 That's an unsettled debate and I do

30:50 acknowledge there's a lot of room for nuance.

30:52 there are some good private market funds at least after the fact

30:56 maybe in some cases before the fact like maybe there are some uh

30:59 there there is some persistence in private markets where you can pick

31:02 good managers who will then continue to outperform um but it's you know

31:07 in a lot of ways it's there there there are also good public

31:12 market funds um but I don't know if that means we should start

31:15 uh embracing active management on balance when you look at the data in private

31:21 markets I'm just not convinced

31:22 that the sales pitch matches the economic reality.

31:29 Um, okay.

31:30 Anything from you guys before we keep going?

31:34 No, I think you should charge ahead, Ben.

31:36 All right, keep keep it going.

31:39 Okay, so we'll look at each asset class real quick here.

31:41 Um, and there is some pretty interesting stuff happening in each one.

31:44 So, private equity invests in private companies.

31:46 uh attempts to increase their value and then

31:48 exit the investment if they can which has

31:51 been a struggle recently as we mentioned earlier

31:53 uh tries to exit the investment at a profit.

31:55 Private equity has multiple underlying strategies with the two

31:58 largest buy assets being buyouts and venture capital.

32:02 Buyouts is the largest segment by assets and that's where firms

32:06 acquire a stake in a larger and more established private company,

32:09 try to um improve it financially and then sell it at a profit.

32:13 Venture capital invests in early stage high

32:15 growth companies with the expectation that a small

32:18 percentage of those companies will be

32:20 massively successful while many will lose money.

32:23 So venture capital uh tends to have very very

32:26 skewed distributions um because of the way that they invest.

32:30 They'll have a few really really big winners and a lot

32:32 of their investments will will be losers in many cases total total losses.

32:37 Uh but that isn't necessarily a bad thing.

32:40 Venture capital can still perform well despite

32:42 the skewess even because of the skewess.

32:45 The private equity industry's value proposition for investors

32:49 in my view really rests on two main pillars.

32:52 Diversification relative to public markets which

32:55 is an interesting question whether there's actually

32:57 diversification there and market beating returns

33:00 which is an even more interesting question.

33:03 These are testable claims sort of but the data can be pretty pretty noisy.

33:08 I'm not going to go through all the research on this topic.

33:10 We we have in past episodes gone into more

33:12 depth on on what the research says about private equity.

33:15 We've also had uh Ludo Falipu on who has

33:19 done a lot of the research on private equity.

33:21 Uh so we've had a conversation with him.

33:23 People want to dig in to this stuff more, they can listen to those episodes.

33:27 Um I I think a big point here and this is

33:31 one of the points that can be quite contentious is

33:34 net of fee private equity returns can be largely replicated using

33:39 public stocks selected to match the characteristics of private equity holdings.

33:44 That's a big that's a big point.

33:46 Um and then another important point is that when you adjust private equity

33:50 returns for the fact that private company shares are not valued every day,

33:54 there is a dramatic reduction in any diversification benefit that may have

33:59 been observed with raw private equity with the smooth private equity returns.

34:04 So I mean another way to say that is that they're a lot more volatile and a lot

34:08 more correlated with public markets than uh than

34:11 the private equity returns appear sort of on on paper.

34:15 So that's that concept of volatility laundering or smoothing as a service.

34:18 Uh just because you don't see the price change

34:21 every day doesn't mean that the assets value isn't fluctuating.

34:25 Uh priv private equity fund might look

34:27 really stable on paper while its underlying economic

34:29 risks are very similar to or maybe

34:31 even more extreme than uh public market equivalents.

34:35 Another issue is that there's massive dispersion in private equity fund returns.

34:39 many there's a huge gap between the best and worst funds which

34:42 increases the the penalty for choosing uh the wrong the wrong funds.

34:49 I think that part just saying is you know going back to the the IV portfolio you

34:55 know that with these famous sort of um uh

34:59 portfolio allocations that uh institutions gain so much um

35:06 attention for they cannot be replicated right because it's

35:10 one thing to say well you know we invested

35:12 in broad market US equities you can do

35:15 the same it's another thing for an institution to say,

35:18 "We bought a thousand acres of timberland in the northeastern US.

35:23 You should do the same."

35:25 So the and the the dispersion is where everything breaks down here, right?

35:29 It's just not a replicable investment strategy on the retail level.

35:36 Yeah.

35:37 So ju just on performance,

35:38 I want to read a a quote from a recent paper from Ludo Falipu.

35:44 Um just so it's not me you know handwaving this away.

35:48 This is coming from um Ludo's research.

35:52 He says private equities reported outperformance over public markets

35:56 largely disappears once consistent benchmarks and definitions are applied.

36:00 The average PME that's the public market equivalent

36:02 which is a way of measuring private equity performance.

36:04 Uh PME values remain near near parody with appropriate public equity indexes.

36:10 Um, so that's that's that's is debated in in the literature.

36:15 There are other papers that find out performance.

36:17 Ludo says when you do it properly, there's no outperformance.

36:20 But I mean, just the fact that this point is contentious,

36:23 I think is is interesting and we'll come back to that later.

36:26 Ben, you had something?

36:27 Yeah, I just find that fascinating and like makes me think of investor behavior.

36:33 like everybody is always trying to find the next

36:36 best thing that's going to give them an edge

36:38 over the market and this is just another category

36:41 of of possible outperformance or the hope of possible outperformance.

36:47 Yeah.

36:47 Another interesting point is that the the prefee

36:50 returns of private equity have been massive.

36:52 It's the net of fee returns that have been in line with public markets.

36:57 Like they they tend to charge high fees and there are multiple layers of fees.

37:02 Ludo said that total fees can end up being around 6%,

37:06 although Larry says fees come down a lot since,

37:09 you know, relative to the historical data,

37:12 which is another interesting point that we'll come back to later.

37:15 Um, but the fee problem is not the only issue plaguing private equity right now.

37:20 the the current state of private equity as we mentioned earlier is

37:22 that a lot of funds have been unable to sell their holdings,

37:26 not to meet investor redemption requests necessarily,

37:29 but just to turn over their holdings at a normal pace.

37:32 And so the result has not been falling prices for these unsold companies,

37:36 which is probably what we would see if they were publicly traded companies,

37:40 but instead it's shown up in the rise of more

37:42 creative ways to get cash back into the hands of investors.

37:46 One prominent example of that is something called continuation funds.

37:50 That's a fund that buys portfolio assets from an existing private equity fund

37:54 often managed by the same manager to give the fund the initial fund liquidity.

37:59 Um so now we have these continuation funds.

38:01 An increasingly common investor in continuation funds are

38:04 a new a relatively new structure called evergreen funds.

38:09 So these are semi-liquid vehicles that promise ease of use for investors like it

38:13 it behaves more like a mutual fund instead of a traditional private equity fund.

38:18 Uh and it also gives man fund managers flexible capital which can

38:21 be used to support continuation funds

38:23 and make other other private market investments.

38:27 Evergreen funds have typically lower barriers

38:29 to entry than a traditional private equity fund.

38:32 And because they offer more liquidity,

38:34 they're supposed to be more accessible to retail investors.

38:37 Now these things have become an important source of secondary market capital.

38:41 So that's the the continuation fund idea.

38:44 So buying buying private equity holdings from existing private equity funds.

38:48 I think they maj they they raise a major

38:50 concern um which is that the fund manager often

38:53 controls both sides of the deal if the evergreen

38:56 fund is buying an asset from another private equity fund.

38:59 So this makes the accuracy of the secondary market valuations kind

39:03 of murky and I think it creates conditions for adverse selection.

39:09 Um I I I think a reason that investors

39:11 can buy into these evergreen funds relatively easily

39:13 is that the manager has investments in existing

39:16 funds nearing maturity that they have not yet sold.

39:18 So there's this kind of structural need for exit liquidity

39:21 to pay off original investors in in private equity funds.

39:25 As we mentioned earlier,

39:26 private equity funds typically want to exit their investments

39:28 to an outside buyer after a few years.

39:31 But if they instead sell the assets to an evergreen fund that they also manage,

39:36 it may indicate that they had struggled to find an external buyer,

39:40 which I think suggests the assets might not be something that you want to buy.

39:44 I think there's a real risk that you're buying, you know,

39:46 a lemon that the broader market would not have touched at the price

39:50 that you were buying it for through

39:52 the evergreen fund structure or continuation fund structure.

39:55 Now, that's not necessarily always the case.

39:57 Maybe you're getting a great deal.

39:59 Maybe you're buying into some company that's going to win big in the future.

40:02 I don't know.

40:02 But that's the problem.

40:04 You you don't you don't know.

40:05 You're not buying at a market tested valuation.

40:08 And then we add on top of that the the of that risk the the sort

40:12 of valuation risk that that net of fees

40:14 the average private equity fund has performed

40:16 in line with um with public market equivalents

40:20 and I would say that investors in these evergreen

40:22 vehicles may be taking on significant complexity

40:24 and valuation risk without being properly compensated for it.

40:29 Uh another interesting thing that's been

40:32 happening uh with the liquidity situation is

40:37 that some investors have been selling

40:39 their stakes in private equity funds at discounts.

40:43 So say you've invested in a private equity fund but you but you need some cash.

40:48 The fund isn't liquid but you can find someone

40:50 to buy your stakes from you at a deep discount.

40:54 So the the the the thing that has risen

40:56 from this phenomenon is something that's been called NAV squeezing,

41:00 which is like this this stuff gets pretty crazy.

41:03 Um so an example that I read about is with uh Harvard and and Yale.

41:08 So they've as we mentioned they've

41:09 got pretty significant private equity holdings.

41:12 Yale was one of the early adopters.

41:14 Um now normally these guys would wait many years

41:18 for their private equity funds to exit companies and distribute

41:21 the cash back to them as the investor which

41:23 is kind of the normal uh course for those investments.

41:26 Uh historically that has worked out but recently

41:30 universities have needed cash and been forced to sell

41:33 their private equity fund stakes sooner than planned uh

41:36 just to free up cash to to fund their operations.

41:39 So Harvard Neil had been selling parts of their private equity portfolios

41:43 to secondary buyers at discounts and those discounts have averaged around 11%.

41:48 So this discount is a markdown from the position's net asset value.

41:52 So the fund manager says the this is the this is the net asset value.

41:56 This is what we think or what our maybe external valuator thinks

42:00 that the assets are worth net asset value which is an important concept.

42:04 Now the trick here and this is as I said this gets crazy.

42:08 The secondary market buyers can put the purchase price on their own books.

42:12 So they say yeah we bought this at at a discount but they can immediately

42:16 mark it back up to its net asset value in calculating their own net asset value.

42:23 So, if Harvard sells a $100 million fund stake at an 11% discount,

42:28 the secondary market buyer of that fund stake can purchase it for $89 million,

42:33 but then immediately mark it back up

42:35 on their books to $100 million because that was

42:38 the funds NAV that they just purchased despite

42:40 the fact that they paid $89 million for it.

42:44 And this is all kosher with the accounting rules as I understand it.

42:48 So on paper, this purchase for the secondary market

42:51 buyer of the fund stakes generated an immediate 12.3% return.

42:54 That's $1 million on $89 million.

42:57 Even though nothing about the underlying value of the companies has changed.

43:01 I mean, it's it's it's pretty crazy.

43:04 That's pretty convenient way to juice your returns, isn't it?

43:08 Yeah.

43:07 Yeah.

43:08 Buy something at a discount and claim it's worth whatever

43:13 whatever you think it's worth.

43:15 Yes.

43:15 Uh that's hard to believe that that is all above board.

43:19 I'm presumably it is.

43:21 I'm not accusing anybody of anything except that that's bizarre.

43:25 Yeah.

43:25 Yeah.

43:25 Yeah.

43:26 And it is.

43:26 It is.

43:27 As I understand it, it's all totally above

43:29 board with the way the accounting rules work.

43:32 Uh now there have been a lot of secondary market sales sales.

43:35 There there were $162 billion of secondary market sales last year.

43:40 Um now I mean for the universities for for Harvard

43:43 Yale in this case they they were able

43:44 to free up capital like they they got liquidity

43:47 which is great the the market mechanism worked for them.

43:51 Um whether the people in the funds that bought

43:54 the assets are actually getting a good deal.

43:56 I mean on paper they are but you know it's a little sketchy I think.

44:02 Now, where this gets even crazier is that some fund managers

44:05 have adapted their fee structures to uh kind of accommodate this setup.

44:11 So, Hamilton Lane, there's an article I

44:13 think in the Wall Street Journal about this.

44:15 They updated their fee structure to collect performance

44:18 fees based on unrealized gains rather than the more

44:21 typical practice of waiting until uh underlying holdings are

44:24 actually sold to calculate their um their performance fees.

44:29 uh they took in apparently $58 million

44:32 in incentive fees shortly after changing the fee

44:34 structure um which they may not have otherwise

44:37 seen for many years under the old rules.

44:40 So I you know I do think this smells a little a little

44:43 fishy um some people speculate and this is mentioned in that article

44:49 um that this change was made by Hamilton Lane because they themselves

44:53 may suspect that the high paper valuations are not going to last.

44:57 like they're they're collecting performance fees

44:59 on that increase from in the previous example 89

45:02 million to 100 million like oh look

45:04 at the gain we'll collect some performance fees

45:11 yeah and we now bring this to retail right when retail investors are are sold

45:15 on the idea that these private equity funds

45:17 are generating these large returns and that retail investors

45:20 are buying into that I think that's problematic

45:24 um the the paper returns might might be a lot higher higher than what you can

45:28 actually realize by by selling the the investment.

45:33 Um, another current concern in is

45:36 the industry's heavy exposure to software companies.

45:39 Private equity has gone pretty heavily into into software.

45:44 Um, and you know, there are lots of concerns right now.

45:47 Software's been hit in general.

45:49 Um, people are worried about AI affecting software.

45:52 Whether that's a real concern or not remains to be seen.

45:55 Uh but it's just another another potential issue there.

45:58 Uh this is also affecting so that the issues

46:02 in private equity are also affecting private credit.

46:05 Private credit has been one of the big funders

46:07 of the leveraged buyouts that are happening in private equity.

46:11 So in private equity,

46:11 you go and borrow a bunch of money to buy a company who's lending it to them.

46:16 It's private credit.

46:18 So private credit consists of loans to private companies kind

46:21 of like a bond except the loans are not publicly

46:23 traded and they're created by non-bank entities like private credit

46:26 funds or business development companies uh or or BDC's for short.

46:31 So these funds raise money from investors and then make

46:33 direct loans often with flexible terms and covenants to private companies.

46:37 Uh the loans by their nature are risky.

46:40 um their loans to private companies and like private equity,

46:45 private credit funds don't have their assets marked to market daily.

46:48 So this again allows them to appear low risk even if the value

46:51 of their underlying assets would be fluctuating pretty wildly in public markets.

46:56 And again like private equity when the returns

46:58 on private credit funds are properly evaluated against risk

47:01 appropriate benchmarks I don't think there's anything special there

47:04 which is again you know that can be debated.

47:08 One important point is that similar to publicly traded high yield bonds,

47:12 private loans often share return characteristics with riskier stocks.

47:16 They kind of look like a a mix of stocks

47:18 and bonds if you do like a factor decomposition of their returns.

47:22 Now, this asset class has seen enormous growth,

47:25 but it's recently started to see investors wanting their money back,

47:29 and due to the illquidity in the underlying loans,

47:31 some private credit funds have had to gate redemptions.

47:35 So again, put yourself in the shoes of the investor.

47:38 You put your money in a private credit

47:39 fund to try and get some nice juicy yield.

47:42 Uh maybe you start to feel a little bit uneasy about the underlying assets.

47:46 So you you ask for your money back.

47:48 But the problem is, and you mentioned this earlier, Ben,

47:51 uh people usually start to feel uneasy at around the same time.

47:54 So when everyone wants their money back, the private credit fund says no.

47:58 Now again, I mentioned this earlier, that is a feature, not a bug.

48:01 at least if you're the fund.

48:03 Private loans are long-term loans.

48:05 They're not expected to be liquid.

48:07 They're not designed to be liquid.

48:09 Investors in these funds should understand that going

48:12 in, but that's a lot easier said than done,

48:14 especially when we're talking about retail investors,

48:17 as you mentioned earlier, Dan.

48:19 Uh, in some cases, gated funds can be locked up for years.

48:23 You you also mentioned that earlier, Ben, it can be painful.

48:26 um publicly listed business development companies

48:30 are are a pretty interesting contrast.

48:32 So they're uh rather than gating they feel the full force

48:36 of the market's assessment of the value of their underlying loans.

48:38 They are publicly traded.

48:40 So it's like a it's like a private credit fund

48:42 that's publicly traded basically is what a a BDC is.

48:46 So the FS KKKR Capital Corporation is one interesting recent example.

48:53 It reported an increase in troubled loans and lower investment

48:56 income from its loan portfolio and the market responded swiftly.

49:00 The fund is down significantly for the 12 months ending February 20 27th.

49:08 Another one was was uh the midcap financial

49:11 investment corporation similarly marked down some of its loans

49:14 and was you know recognized by the market

49:16 for for their their honesty and their in their markdowns.

49:19 got got smacked pretty hard by public market pricing.

49:24 So I I really think that the the publicly traded

49:26 BDC's indicates how much risk private credit funds are taking.

49:30 I mean, these things are taking serious hits to their market

49:33 prices while private credit funds are like, "No, no, no, no.

49:37 It's cool.

49:38 NAV's good." But it's, you know, it pro probably isn't,

49:41 especially when you consider that a lot of the funds are being uh gated.

49:47 And this is just a fundamental truth.

49:49 When you have risky underlying assets,

49:50 you're either going to get volatility or if

49:52 you don't want to see the volatility, you're going to get illquidity.

49:57 Uh, I mentioned this earlier, but one of the problems with ili liquidity is

50:00 that you have to own assets that, you know,

50:02 kind of stink and you have to continue paying fees to own them.

50:05 And to your point earlier, Ben,

50:06 you don't know if you're actually going to get your money back.

50:09 Like, you don't know how much value you're

50:11 going to realize on the on the gated portfolio.

50:15 Uh, so here's another one.

50:17 So, we talked about nav squeezing for private equity.

50:19 This is another crazy thing that's been happening.

50:22 uh uh life insurance companies traditionally keep

50:26 their large cash reserves in in stable conservative investments.

50:31 Private equity firms have been buying insurance companies

50:35 and then moving significant amounts of the insurance

50:37 company portfolio into private credit managed

50:41 by the same the same private capital manager.

50:46 So this is just basic stuff like insurance companies take in insurance premiums.

50:49 they they eventually have to be able to pay out uh benefits when

50:52 someone dies or gets disabled or whatever whatever type of insurance it is.

50:56 But in in the interm sitting on hand

51:00 can be invested and the insurance company does get

51:03 to keep the the difference between what they earn

51:05 their investments and what they pay out to policy holders.

51:08 Um but this this recent playbook has emerged where

51:11 private equity is buying the insurance company stuffing its

51:14 portfolio with private credit funds from lenders owned

51:17 by the same private equity company that owns the insure which

51:22 are insurance companies not highly regulated in what they

51:25 can invest in to avoid this kind of thing.

51:28 I I would have to look into the details on regulation.

51:30 Um but there have been a bunch of articles about this happening.

51:33 So I mean it must be above board for it to be you

51:36 know public knowledge that it's that it's happening but uh I I think it

51:40 is creating this sort of closed loop of risk that you know it could

51:44 it could be really bad if if the risk materializes in in private credit.

51:50 Yeah, I don't know the rules either,

51:51 but if it's happening because private companies are buying it,

51:55 maybe that's a a loophole to be able to once you own your own insurance company,

52:00 then you can offer your own products inside of the insurance fund itself.

52:03 But we'd have to yeah, dig deeper on that.

52:06 Yeah, I'm not super up to speed on on the insurance regulations.

52:09 This is mostly US-based, too.

52:12 Uh yeah, so this this has been happening all all over the place.

52:17 Um now the the these risks that we're talking about

52:20 with private equity and private credit I mentioned the publicly

52:22 listed BDC's but it's also showing up in the equity

52:26 values of uh publicly listed players in in this space.

52:31 So uh managers of private equity and private credit or just private funds

52:36 in in in general uh their share prices

52:39 have gotten just obliterated in in recent history.

52:42 So the market is really recognizing that hey

52:44 there there are real potential concerns happening here.

52:49 Uh okay real quick I want to mention private real estate.

52:52 So private real estate funds there they

52:54 directly own real estate assets like apartment buildings,

52:56 office towers and shopping malls.

52:58 Um as we talked about earlier it's a pretty simple narrative.

53:02 They can have various strategies but the general idea of owning real

53:06 buildings inside of a private fund is is consistent across this asset class.

53:10 They're often not unlike publicly traded REITs except

53:14 that the private funds don't trade on the stock market.

53:16 Um like private equity and credit.

53:19 Some of some of these private real estate funds in Canada for sure.

53:22 Uh I have not checked out the US,

53:25 but in Canada they have recently struggled with liquidity.

53:28 I don't think that's too surprising right now.

53:30 Canadian real estate has experienced its worst real

53:33 price decline going back to 1975 in recent history.

53:37 uh public residential real estate REITs have

53:39 taken a beating and private fund managers understandably don't want to be forced

53:45 to sell assets that have declined in price.

53:48 Now again, that's fine and that's why

53:50 their contracts with their investors allow them to gate

53:53 their funds in the midst of the liquidity

53:55 crunch for many Canadian private real estate funds.

53:59 Some are considering going public, which is interesting.

54:01 So being public means that investors can buy and sell their shares

54:04 on the open market without the fund needing to sell its underlying assets,

54:08 but it also exposes the value of the fund's units to market prices.

54:13 Uh so in the case of this Canadian fund,

54:16 they they have halted redemptions for current investors.

54:19 Will they consider going public?

54:22 I don't know what will happen with this IPO

54:23 or if they even will choose that direction.

54:26 Um that's they're just considering it.

54:27 But there are a couple of interesting

54:28 examples from the US where this did happen.

54:31 So in November of last year,

54:33 FS Specialty Lending Fund listed on the New York Stock

54:36 Stock Exchange at a net asset value of $18.67 per share.

54:41 On the end of its first day on the market, it closed at $14.

54:45 And then in December,

54:46 Blue Rock's Total Income Plus Real Estate Fund began trading on the New

54:49 York Stock Exchange with a stated NAV of $24.36 a share.

54:54 And at close, the fund was trading at a market price of $14.70 a share.

54:59 That's a 40% That's a bad day.

55:02 40% draw down.

55:03 Very bad day.

55:05 Yeah.

55:05 Uh so I, you know, is an IPO the right way to exit a a private fund?

55:10 I mean, yeah, like I said earlier,

55:12 you're going to get ili liquidity or you're going to get volatility?

55:16 Um, and if you don't want the liquidity,

55:19 it's going to it's going to show up as volatility

55:21 as we saw with those two those two examples.

55:24 Um, I think another kind of like what we talked about with private equity.

55:28 Another fundamental question is whether private real estate funds are

55:32 adding anything special that can't be found in a public read.

55:35 And I would summarize just real quick on that that there's

55:40 not a ton of evidence that private real estate has outperformed public.

55:45 they're they're really exposed to the same underlying economic factors.

55:49 Uh so there's not there's not really anything special there.

55:52 We did hear from Mambdu Medat from Dimensional who had

55:54 done a study on private asset funds that there may be

55:57 some uh diversification potential left over like some meaningful diversification

56:02 potential left over even after this return smoothing is accounted for.

56:05 So may maybe there are some arguments there.

56:08 But the idea that you're going to get um much

56:11 higher returns or much less risk in private real estate,

56:14 I don't think similar to the other other asset classes we talked about,

56:17 I don't think there's a whole lot of uh meat there.

56:21 Anyway, so I I think private markets have

56:23 been sold to investors as a way to increase

56:25 their expected returns without increasing and maybe even decreasing

56:28 the amount of risk they're taking relative to public markets.

56:31 Recent red flags in private equity, credit,

56:33 and real estate have shown that these assets are at least as risky

56:36 as their public counterparts and may be hiding

56:38 additional layers of risk due to high fees,

56:40 ili liquidity, and less scrutiny in how assets are valued.

56:43 I know I can say that I'm I'm very glad that PWL did not jump head first

56:48 into the space when it started getting pushed really hard

56:50 through the wealth management channel and and toward retail investors.

56:54 And I hope retail investors will approach

56:56 these assets carefully as they continue to be promoted.

57:00 And of course, as always, if you want to know more about

57:02 PWL's super boring investing philosophy, which is awesome,

57:07 awesomely boring, you can get in touch with uh

57:10 with us and talk to one of our adviserss.

57:13 Our super boring adviserss super boring like Dan.

57:18 That's right.

57:19 I'm nodding off just thinking about it.

57:25 Uh okay, so that was the main topic.

57:27 I I do want to just real quick go through Larry Swedro's comments.

57:31 Uh so Larry's been a big proponent proponent of private assets.

57:35 He holds a big portion of his own investments in private assets

57:38 and it's his view that investors should be investing in private assets.

57:42 Um so someone asked him to comment on my video

57:46 and he shared his comments in the rational minder community.

57:49 So I'm going to read Larry's comments and offer

57:50 my thoughts which I also posted in the rational minder community.

57:54 I do want to preface this by saying that Larry is he's a legend.

57:57 He taught me a lot of what I know about financial markets and investing.

57:59 I think that's probably true for all of us.

58:01 Um, nothing but respect for him,

58:03 even if we don't necessarily agree at the moment on this topic.

58:06 And maybe we will end up agreeing.

58:08 Maybe Larry will change my mind.

58:10 We'll see.

58:11 So, Larry says, "Ben's a very smart guy, which I appreciate.

58:14 And much of what he says in the video is correct.

58:16 In fact, 5 to 10 years ago or so, I would have said the same things.

58:19 But when things change, smart people re-evaluate their decisions,

58:22 not stubbornly sticking to prior decisions based on old facts.

58:27 Okay.

58:28 Uh so yeah, my my response there is just

58:33 on the on the new facts that private equity may have outperformed.

58:36 I think there's a lot of issues

58:37 around whether private equity has in fact outperformed.

58:40 Uh everything really hinges on that point.

58:43 So Larry references a recent paper from some of the folks at MSCI who have

58:46 a huge private markets data business

58:48 and that paper shows that private equity has outperformed.

58:51 But a paper in the same journal from past rational minder guest

58:55 Ludo Phalipu explains that private equities I I read read this quote earlier.

58:59 Private equities reported outperformance over public markets largely

59:02 disappears once consistent benchmarks and definitions are applied.

59:06 Average PME values remain near parody with appropriate public equity indexes.

59:11 I think at best the fact and I put that in air

59:13 quotes in my notes that PE has outperformed is contentious.

59:18 And there's similar research coming out on private credit suggesting

59:20 that it performs in line with comparable publicly traded assets.

59:24 I think the fact that this is a debate at all is to me a huge problem.

59:28 Uh Eugene FMA referred to the the same

59:30 issue when he was on rational mind years ago.

59:32 We asked why not include private equity

59:34 in portfolios since it's part of the market.

59:37 FMA said what is the expected return on private equity?

59:39 The data don't give you a good answer to that because they're so self selected.

59:43 You only get to see the ones that survived pretty much.

59:46 So you don't get to see how much money was

59:48 put in there that blew up and was totally lost.

59:51 And that's very important.

59:52 Very important.

59:53 If I were on your side of the table

59:54 and I had to advise advise investors what to do,

59:58 I don't know what I would do about private equity because I don't

1:00:00 think the data are good enough for me to give you an answer.

1:00:03 So just that alone, just the fact that this is a debate to me is is problematic.

1:00:10 Mhm.

1:00:10 Uh Larry's next criticism.

1:00:12 Ben unfortunately missed two very important points.

1:00:14 there is a significant illquidity premium

1:00:16 in return for the illiquidity potential.

1:00:19 My response is that this statement

1:00:21 really depends critically on on the evaluation

1:00:23 of private equity outperformance or or or lack

1:00:26 thereof or any private asset class.

1:00:28 If we can look and say, "Yep, it's outperformed, then hey,

1:00:31 maybe that's evidence of an illquidity

1:00:32 premium." If we don't believe it's outperformed, then maybe there isn't.

1:00:36 Um, and again, I don't think this is super obvious.

1:00:40 uh auntie Elmanin when he was on rational minder explained that people are

1:00:44 willing to pay for ill liquidity because it provides smoothing as a service.

1:00:49 It makes returns look more smooth than they really are

1:00:51 which may diminish or even negate entirely any illquidity premium.

1:00:57 Uh Larry says Ben's statements about Ben Ben's statement

1:01:00 about returns and risk relative to public markets was true.

1:01:04 And Larry says that he did write that in his books and articles.

1:01:08 But what I what Ben sadly failed to mention is that fees

1:01:11 have come way down allowing investors to capture more of the premium.

1:01:15 My response is that it this really seems to ignore the economics of manager

1:01:19 skill which was thinking pioneered by Burke and Green in a 2004 I believe paper.

1:01:24 We had Jonathan Burke as a past guest

1:01:26 who talked about his research on this topic.

1:01:28 Lowering fees in a competitive market increases the amount

1:01:31 of assets that a skilled manager can handle,

1:01:34 but it doesn't create automatic alpha for end investors.

1:01:37 The economics of manager skill is basically that manager's funds

1:01:41 will grow large enough to the point where the benefits

1:01:43 of the skill are fully absorbed by the manager and investors

1:01:48 earn returns in line with the amount of risk they're taking.

1:01:50 But the only way to get outperformance is to identify

1:01:53 a skilled manager that the market has not yet identified as skilled.

1:01:58 So lowering fees just increases the capacity of a manager

1:02:01 but doesn't necessarily result in alpha for investors.

1:02:05 And with the massive influx of of capital into private markets,

1:02:08 it seems sensible to believe that alpha opportunities are increasingly scarce.

1:02:13 Um Larry says private assets can be more tax efficient like real estate where

1:02:18 most of the returns are are return of capital not ordinary income like 90% plus.

1:02:24 That's a reasonable point um and not something that I've honestly spent

1:02:27 a whole lot of time digging into uh because we're not using private funds.

1:02:33 Uh Ben also failed to mention that unlike in public markets,

1:02:36 there's strong evidence of persistence in private

1:02:38 markets and for good logical reasons

1:02:40 on which papers have been written and Larry did list some of those reasons.

1:02:44 So if you can gain access to top quartortile funds,

1:02:46 you greatly improve your odds which changes the math

1:02:48 and the findings of academic papers which look at averages greatly.

1:02:54 This is a tough one.

1:02:54 I I don't think the evidence here is so strong

1:02:56 to support an argument that you should be in private markets.

1:02:59 The strongest evidence of persistence, as I understand it,

1:03:02 is in venture capital where adverse selection is also very strong.

1:03:06 The best VC funds won't give you the allocation you want.

1:03:10 They just won't.

1:03:11 And we've been through this with with clients trying

1:03:13 to get access to the best V VC funds.

1:03:16 Even with the best connections and so on and so forth,

1:03:19 you will not get the allocation that you want,

1:03:21 if you can get an allocation at all.

1:03:23 Sometimes they just won't answer your calls

1:03:25 for the best like the top V VC funds.

1:03:27 Um, persistence in buyouts is in the worst performers.

1:03:32 So, the bottom quartile buyout funds tend to continue to be bottom quartile.

1:03:36 So, you can avoid them.

1:03:37 But you can't look at past winners and assume

1:03:39 that they're going to continue winning in in buyouts.

1:03:42 That there was also a recent paper in the journal of private market

1:03:45 investing that suggested that even if there

1:03:47 is some persistence in private equity funds,

1:03:49 it's not typically investable persistence based on information

1:03:53 that's available at the time of making investment decisions.

1:03:56 So, this is pretty interesting.

1:03:56 Basically, you need to wait until a fund has realized

1:04:00 its investments like sold the underlying holdings and and uh

1:04:03 and shut her down uh so that like fully matured um

1:04:07 in order to observe the performance that may predict future performance.

1:04:10 But manager manager managers are typically raising their next

1:04:14 fund before their previous fund has fully distributed.

1:04:20 Anyway, persistence could be a good argument to be in private markets,

1:04:23 but I I just don't know if the data are that that convincing,

1:04:27 similar to the outperformance concept more generally.

1:04:30 Larry says, "Ben failed to mention that private assets

1:04:32 are actually less volatile in valuations due to the fact

1:04:35 they're not influenced by investor sentiment and panic selling where

1:04:38 you have massive market massive market impacts costs in panics,

1:04:42 but the underlying businesses have not been impacted." I struggle with this one.

1:04:46 Investor sentiment is still there in private funds.

1:04:49 It shows up as funds gaining redemptions rather than marktomarket volatility.

1:04:53 And I think that's what we're seeing happening right now.

1:04:56 Right now.

1:04:57 Uh Larry says, "Tell Ben to invite me on the podcast so we

1:05:00 can shed more light on the topic." I'm totally down to do that.

1:05:03 Uh but I do want to spend a bit more time exploring the topic first.

1:05:08 All right, that is it.

1:05:12 Any parting thoughts?

1:05:13 I find that just the discussions interesting

1:05:15 and it's good to have these healthy debates

1:05:18 to explore both sides so that investors can

1:05:20 make an informed decision one way or another.

1:05:24 Yep.

1:05:24 Yep.

1:05:25 We'll keep we'll keep exploring the topic.

1:05:28 There are some other interesting guests that I that I'm interested in talking

1:05:31 to and and totally open to having Larry on at some point,

1:05:35 but I do want to I do want to do a bit of my own exploring first.

1:05:38 I I kind of already know what Larry's going

1:05:40 to say and I'm totally happy to hear it,

1:05:42 but I want to explore more perspectives first.

1:05:46 Uh, okay, real quick.

1:05:48 We have a couple reviews.

1:05:51 Uh, got to read the disclaimer here.

1:05:53 We have a few reviews from Apple Podcast to read under SEC regulations.

1:05:56 We are required to disclose whether a review,

1:05:58 which may be interpreted as a testimonial, was left by a client,

1:06:01 whether any direct or indirect compensation was paid for the review,

1:06:04 or whether there are any conflicts of interest related to the review.

1:06:08 As reviews are generally anonymous, we are unable to identify if the reviewer is

1:06:12 a client or disclose any such conflicts of interest.

1:06:15 But as we always say, we have never paid for a review.

1:06:17 And we wouldn't do that because it'd be weird.

1:06:20 Does one of you guys want to read the read the first one?

1:06:24 Sure.

1:06:23 I'll take the first one.

1:06:24 The best.

1:06:24 This pod balances technical analysis and behavioral finance perfectly.

1:06:29 Enjoying back to the beginning.

1:06:31 Enjoying going back to the beginning and listening from the start.

1:06:34 Now, thank you, Ben, Cameron, and team by Chris K519 from Canada.

1:06:39 It's always impressive to me when people go back to the beginning.

1:06:43 I hear that happen often.

1:06:45 Like, I've heard of a few people recently like, "Oh,

1:06:48 I just found out this podcast and I've gone back to the beginning

1:06:51 to listen to everything and I've gotten through 200 episodes so far this year."

1:06:55 Yeah, it's crazy.

1:06:56 It gets increasingly crazy as the podcast gets longer in its existence.

1:07:01 Yes, exactly.

1:07:03 Do you want to read the next one, Dan?

1:07:05 Yeah, this one's really brief.

1:07:06 It just references our interview with Tom Harden and uh it's a short review.

1:07:11 It says, "Riveting by Drew Burgesser from the US of A." So,

1:07:17 that was a very uh uh fun interview to do.

1:07:20 Really interesting guy.

1:07:22 I think a little bit of a departure from what we often do on the podcast,

1:07:25 but my understanding is the uh the feedback has been really positive.

1:07:30 Yeah, people really like that episode.

1:07:32 It's It's one that I maybe we could have done a better job with the title.

1:07:35 I don't know.

1:07:36 But it it didn't like blow up.

1:07:38 That episode should have blown up.

1:07:39 Like that's such a good such a good episode.

1:07:42 Um so if if people are listening to this and did

1:07:44 not listen to the episode with uh Tom Harden,

1:07:47 I highly recommend going and listening to it.

1:07:50 It is, as you mentioned, Dan,

1:07:51 a little bit of a departure from our typical type of content,

1:07:53 but I think it was just fascinating

1:07:56 and uh re really some unique and interesting perspectives.

1:08:02 All right.

1:08:03 Anything else?

1:08:05 We're good.

1:08:06 I think so.

1:08:07 All right.

1:08:07 Good to see you guys and thanks everyone for listening.

1:08:10 See you next time.

1:08:10 Thanks a lot.

1:08:11 See you.

1:08:16 Hey everyone, it's producer Matt.

1:08:18 Thank you so much for tuning in to this week's episode.

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