One of the strongest investment trends of the past couple of decades that has attracted trillions of dollars of investment capital could turn out to have been a meaningless and potentially dangerous distraction.
Private investments in all of their various forms – private credit, direct loans, infrastructure, and private equity – were all sold on the basis of something called the "illiquidity premium".
In simple terms what that means is that there is an additional return available to investors who are very patient and invest in assets that cannot be sold at short notice.
By contrast, people who invest in public markets such as public shares and bonds were seen to be getting a lower return—effectively the price they paid for having assets that can be bought and sold very quickly.
Does the 'Illiquidity Premium' Exist?
The only problem with the whole concept of private investments is that nobody had conducted any exhaustive research into it until now.
And the conclusion is that the illiquidity premium may not exist at all, or only for some very particular periods of time and over certain assets.
The evidence over the past fifteen years is that private assets have simply not delivered what they promised.
Public markets in aggregate have delivered superior returns to private markets, which has meant the trade-off of liquidity versus returns wasn’t necessary.
Big Pension Funds Losing Out
A careful analysis by Bloomberg of the four largest Canadian pension funds which are big users of private investments showed that most of their recent returns were driven by returns in public share markets.
That is a bit of a problem because they were relatively underexposed to public assets while their private assets have dragged down their returns.
“Most allocators have relied on this idea that private markets would generate an illiquidity premium on top of the returns in public markets,” Eduard van Gelderen, the former chief investment officer of the Public Sector Pension Investment Board told Bloomberg.
“This is clearly not the case.”
Starting Point Matters
Some more analysis by Ian Harnett, of London-based Absolute Strategy Research, showed just how elusive the illiquidity premium has proved to be.
In a presentation to Australian institutional investors he showed that since 1990 an index of private equity investments had delivered almost double the return of the S&P 500.
However, if you changed the starting point to 2009, the S&P500 has beaten the private equity index by a cumulative 20%.
Admittedly this was a period in which the mega technology stocks had an outsized effect on US markets in particular but that just shows up one really big benefit in favour of public markets.
In the case of private credit, Hartnett found that the FTSE index of the riskiest public bonds, showed that over the long run they had held their value compared to listed private credit funds, casting doubt on the existence of an illiquidity premium in this market as well.
The other factor his research showed is that the mooted diversification benefits of private assets being quite different from public ones was also illusory.
Private equity and private credit both had comparable exposures to software of 30% and 24%, respectively, which shows they are more strongly correlated and concentrated than many people believed.
'SaaSpocalypse' Hitting Private Funds
That exposure to software has caused some high-profile panic for investors in private credit.
The response from private credit providers is that if you think private credit is in trouble because of loans to software companies, the private equity funds that they have loaned money to have even greater problems.
The so-called "SaaSpocalypse" (software as a service) that has, at least temporarily, ripped a hole in the valuation of listed software companies that are said to be threatened by artificial intelligence is bad enough but imagine if you had a long-term unlisted exposure to the same market?
Another issue for private equity firms has been the glacial pace at which they have made capital returns.
While they keep telling investors to be patient, it is far from clear whether this patience will be matched by higher returns that they could have earned with full liquidity and access.
Exits Getting Crowded with Longer Wait Times
Retail investors in the US have been crowding the exits from private credit funds so much that many of the big firms have imposed 5% asset disposal limits, reducing access to cash.
Even the Reserve Bank has noted this change in the investment timeline with a recent financial stability report showing that the average holding period of private equity investments has increased from five years in 2010 to seven years now.
The RBA noted that these “intensified liquidity pressures for fund investors’’ and had delayed the return of capital and prevented them from redeploying funds or rebalancing portfolios.
Is 'Private' Always More Exclusive?
To some extent, the popularity of “private” assets could also be linked to the perceived benefits of other “private” measures such as private schools and private health insurance.
With private assets harder to access, some investors might believe they are getting privileged access to special assets.
In reality, this feeling of exclusivity may have been an elaborate illusion through which longer wait times for access to your invested capital earns no extra return in exchange for that illiquidity.
There may also be times when some private investments perform well and others when they underperform, which would suggest they need to be used as part of a portfolio to increase diversification.
Also, the discipline forced on to public companies by being valued every day that the market is open seems to remain a powerful force to ensure investor returns remain a top priority for management.
