Thinking About Private Assets? Understand the Liquidity Trade-Off First.

The easy years for private markets are over. Concerns over valuations, liquidity and credit quality are spreading across the $22 trillion sector. Tighter liquidity, rising redemption requests and greater scrutiny of performance are exposing the bargain at the heart of private markets: investors are rewarded for accepting assets that are harder to sell when they need cash. Now, investors face a practical question: are they being properly compensated for the liquidity risk they are taking? It's a question that Rich Evans, professor of business administration at the University of Virginia Darden School of Business, has spent years exploring through his research on investment decision-making, fund performance and financial markets. As private markets become more widely available beyond pension funds and other institutional investors, Evans believes many individuals are confronting liquidity risk for the first time. And his message to them is that higher expected returns should never be considered in isolation. Investors also need to understand the price they are paying to earn them. Higher returns are never free Evans says higher expected returns should not be viewed as a free lunch. They are, at least in part, compensation for accepting the risk that money may not be available when it is needed. 'Part of the higher perceived return from private investments is compensation for liquidity risk,' he says. 'That's a new concept for many high-net-worth investors now gaining access to private debt.' The stability of private markets has always come at a price Between 2013 and 2017, private capital funds distributed between about $600 billion and just over $1 trillion a year to investors. Since then, distributions have slowed. And, as institutional investors pulled back, private capital firms looked beyond their traditional client base. Many launched evergreen funds aimed at wealthy individuals, giving them the ability to redeem capital periodically rather than waiting years for an exit. But periodic liquidity is not the same as the on-demand access many investors are accustomed to in public markets, says Evans. He believes that expectation stems from one of the core investor protections built into US public markets. 'The Investment Company Act of 1940 was set up to protect investors in several ways,' he says. 'One mechanism is disclosure. Another is the ability to liquidate your investment. It's remarkable that I can be in a high-yield bond mutual fund and have my assets converted into cash in such a short period of time. That's one of the primary mechanisms the SEC uses to protect investors.' Liquidity is becoming the market's biggest test The recent slowdown in fundraising has brought liquidity risks into sharper focus. New commitments to US evergreen private equity and venture capital funds rose just 2% year-on-year in the first quarter, down from 55% growth a year earlier. At the same time, rising redemption requests have exposed the tension between offering investors regular access to their money and investing in assets that cannot easily be sold. Evans says liquidity risks become more pronounced as private markets attract a wider range of investors. Greater overlap between investor bases can amplify redemption pressure during periods of stress. He argues that illiquid assets make liquidity risk harder to assess within a broader portfolio, increasing the potential for redemption pressure to spread. 'When you shift to an even more illiquid asset like private debt, and you haven't yet established a framework for protecting investors, it becomes tricky,' says Evans. 'Anytime there's a run on any investment vehicle without some backstop like FDIC deposit insurance provides to depositors, it creates the possibility that others will want to redeem.' What should investors do differently? His advice to investors is to resist chasing yesterday's winners. Strong past performance can be seductive, but it often says more about what has already happened than what comes next. 'Not all that glitters is gold,' says Evans. 'We tend to chase past returns. But one of the most common features of markets is that things that go way up often come way down. Think of it like buying a coat. Do you buy it at its highest price or wait until it's on sale? Don't buy after a period of very high returns. That's a fool's errand.' He argues that the answer is not to keep individual investors out of private markets altogether, but to give them access through professionally managed portfolios that can balance liquid and illiquid assets. 'Liquidity risk is different from market risk. You need enough liquidity in your portfolio,' he says. 'That's why private assets are better held through professionally managed portfolios that can balance liquid and illiquid investments.' Any such vehicles, he adds, would also need limits on withdrawals to prevent liquidity mismatches. Institutional investors have seen this before Big investors have weathered liquidity shocks before. The 2008 financial crisis accelerated the growth of private capital, as tighter banking regulation and lower interest rates pushed pension funds and endowments toward the asset class. But it also changed how many institutional investors think about liquidity risk, says Evans. 'Institutional investors have been dealing with this for many years and as a result are better able to accommodate liquidity risk. Consider 2008. Institutional portfolios experienced dramatic losses, but at the same time institutional investors were still facing capital calls on their private equity investments. Because of that experience, many institutional investors formalized their approach to addressing liquidity risk.' Broader access demands new safeguards The recent bout of volatility is unlikely to halt the push toward retail investors, he says, but it may change how regulators approach it. 'The next phase is about protecting investors. There's a growing push to give retail investors access to private markets, perhaps through retirement vehicles. My hope is that recent events encourage regulators to move more cautiously.'