The rise in popularity of private investments, especially that of private credit, has recently received increased media attention – we think this makes a good moment to detail our latest thinking on the risks of investing in private markets.
Moody’s recently published a report on private investments (and their risks) that received significant press, titled “Private market retail to fuel opportunity but intensify liquidity, asset quality risks.” Their report raises concerns about the risks associated with private investments that could arise should retail investors plunge too quickly and too deeply into this asset class.
This issue has urgent relevancy as there is currently a powerful deregulatory push by the financial industry (but not by Mercer Advisors) to allow retail investors to invest more easily in private equity and private credit, including inside their 401(k) plans and Individual Retirement Accounts (IRAs). This would be a very significant change as these investments have traditionally been the domain of institutional and high-net-worth investors. In most cases, private investments have historically been open only to those who met the Securities and Exchange Commission’s definitions for Accredited Investors or Qualified Purchasers.
Let’s dive in.
An overview of Moody’s analysis
Moody’s notes that “[t]o facilitate growth, asset managers and their partners are innovating new structures to provide points of access for private wealth. ‘Main Street’ investors are becoming more important as institutional investors bump against capacity constraints in their alternative investment allocations… as retail money flows to private markets, liquidity risks will grow.”
Moody’s highlights several trends in their report:
- Fewer public companies: Private markets are becoming more important as fewer companies are publicly traded, as companies rely on venture capital for longer, opt to remain private rather than tap into public markets, or even delist from public markets.
- Limited availability of high-quality assets: As new investors enter the asset class, they may encounter a limited supply of quality assets.
- High fees: Private investments almost always contain high fees (relative to public market investments).
- Liquidity mismatch and a potential rise in systemic risk: Private markets have traditionally been illiquid, but managers are offering new and untested products that attempt to give retail investors liquidity in these investments.
Now, let’s take each of these points one at a time.
Fewer public companies
The number of public companies listed on U.S. exchanges has declined from a high of approximately 8,000 in 1996 to its current level of 4,600. Reasons often cited for the drop include mergers and acquisitions, fewer IPOs, and the high regulatory and compliance costs, especially post-Sarbanes-Oxley, associated with being publicly traded.
It’s this decline in publicly traded companies that some argue is fueling investor interest in private investments. While we think this is partly true, the bigger drivers in our view are twofold.
First, investor portfolios allocated to private markets benefit from greater asset class diversification. Even if the number of publicly traded companies hadn’t declined over the past 30 years, we would still advocate for investors —where and when appropriate — to consider adding size-appropriate allocations to private investments to further diversify their portfolios.
Second, private investments, as a broad asset class, have historically delivered attractive returns to investors. Assets with high expected returns, that also offer additional diversification benefits beyond public markets, are naturally going to attract investors.
But what is a “size appropriate” allocation? Or in other words, how much of a portfolio should be allocated to private markets? This naturally varies by client, but a good rule of thumb, in our view, is that most investors would be well served with a maximum allocation of no more than 20% of their investable assets to private investments, with no more than 3 – 5% allocated to any one fund. Again, these are rules of thumb, not laws of physics. For example, we would naturally relax these percentage limitations for ultra-high-net-worth investors or when allocating to a well-diversified funds of funds vehicle.
Additionally, there is likely a more ominous reason private investments continue to gain in popularity: marketing — lots and lots of marketing — that leads many investors to feel that they’re “missing out” by not investing in private markets. Asset managers have large incentives to push private investments given the higher fees they charge for such products. They therefore invest more aggressively in product development and the marketing of private investments. And it’s for reasons such as these that we believe it’s critically important to have a trusted, experienced fiduciary in your corner who can identify, navigate, and potentially mitigate these risks.
Limited supply of quality assets
There is a very real risk that smaller, less-informed investors may be left with private investment opportunities that institutional and high-net-worth investors don’t want. Consider the following chart which shows the gap in performance between top quartile and bottom quartile investment managers.
Consider public markets, represented in the chart as “Global Large Cap Equities”. The top 25% of managers returned 9.3% a year from Q4 2014 to Q4 2024, while the bottom 25% of managers returned 7.5% a year. We would not conclude that manager selection doesn’t matter — an extra 1.8% per year over the course of a decade is significant — but the dispersion is relatively small when compared to other asset classes.
Now, consider global private equity. The top 25% of managers returned 22% per year (or more), while the bottom 25% returned at most 1.6% — a staggering performance gap of more than 20 percentage points.
The takeaway from this data is that manager selection matters tremendously to performance. Rushing to invest in any off-the-shelf manager could be disastrous. Therefore, the real question is whether smaller investors will be effective at identifying and accessing good managers in advance. This will be especially difficult since it’s likely that the best-performing managers will continue to raise all the capital they need from large institutional investors. This could potentially leave small investors with the dregs of the asset class.
High fees
As mentioned above, it is certainly true that fees are higher for private investments. These fees create a powerful incentive for asset managers to develop and sell private market investments. A traditional private equity fund typically charges fees of 2% per year on all assets (or committed capital) plus a performance fee equivalent to 20% of all gains.
It’s not uncommon for some products, often sold through major brokerage firms, to charge as much as 5% per year on assets plus an additional incentive fee of 35% of profits. Finally, annual management and performance fees are just the beginning — funds typically charge as much as an additional 1-1.25% in administrative costs to cover things like accounting and audit expenses. Unfortunately, it’s smaller, less experienced, and less informed investors who will most likely end up paying unnecessarily high fees to access private markets.
We have no objection to good managers earning a good living. Indeed, we want and expect the very best managers to be well-rewarded for delivering strong returns to their investors. However, knowing whether, when, where, and to whom such fees have merit (or not) is critical to investing successfully in private markets.
Liquidity mismatches
Moody’s argues that there may be a potential “liquidity mismatch” as more retail investors enter private markets. The thinking here is that retail investors generally prefer high liquidity, especially during times of market stress. Private investments are, by their very nature, highly illiquid. We traditionally think of a “liquidity mismatch” as a situation where investors use short-term borrowing to invest in long-term assets. This is what effectively fueled the global financial crisis from 2007-2009.
I don’t think individual investors have a monopoly on anxiety during stressful market declines. It is true that all investors, whether institutional or retail, suffer from anxiety during market stress and often seek to raise cash during such times. Moody’s argument that a liquidity mismatch may exist is more a comment about the likelihood that retail investors will be disappointed if and when they realize they’re unable to liquidate their private investments during difficult markets. It is not an argument in my view for an increase in systematic risk because most private funds simply disallow investor redemptions — this is very different from bank runs, where depositors can choose to withdraw their bank deposits at a moment’s notice.
Private investment vehicles are purposely designed to either limit or flat out disallow redemptions from their funds. While most private equity funds begin returning capital to investors in years 5 or 6 of the fund’s life (sooner for private credit funds), they don’t typically finish doing so until year 10 or later. A typical private equity fund is designed to last anywhere from 10 to 12 years, sometimes longer. Some relatively new fund designs, such as interval funds, allow investors to collectively redeem up to 5% of funds of assets monthly or quarterly (varies by fund), but such vehicles also often allow fund managers to “close the gate” and suspend distributions during times of market stress (and at their discretion).
The takeaway is that investors should work closely with their advisors to carefully evaluate their family’s liquidity needs and ensure that they understand any prospective funds’ liquidity provisions before investing.
Our approach to private markets risk management
At Mercer Advisors, we provide access to private markets in several ways. One of those is through our diversified, low-cost Aspen Partners funds. These are funds of funds vehicles available to clients of Mercer Advisors who are “qualified purchasers”. The designation “qualified purchaser” is defined by the U.S. Securities and Exchange Commission. The Aspen Partners program is only available to investors who meet the SEC definition.
The approach taken by Aspen Partners has the following features that were designed taking into account the specific risks of private markets investing:
- Institutional-grade access. As one of the largest independent registered investment advisors in the U.S., the size of Mercer Advisors affords us access, expertise, and resources that many smaller firms and investors simply can’t match. We leverage our institutional buying power to secure access, often on preferred terms, to some of the very best opportunities in the market.
- Extensive private markets expertise. Investing in private markets is very different from investing in stocks, bonds, mutual funds, and ETFs. It’s an entirely different world, with its own vernacular, metrics, social circles, and timelines — much of it foreign to even the most experienced advisors and investors. At Mercer Advisors, we have a dedicated, highly experienced team of private markets experts who source, underwrite, and invest in private investments on behalf of our clients.
- Lower minimums. Because we act as a sort of “buyers’ cooperative”, we’re able to meet the often-high minimums required by the best managers. For example, it’s not uncommon for top funds to have minimums of $5 million or more. However, with as little as $100,000, our clients can participate in these investments via one of our Aspen Partners funds of funds vehicles.
- Lower costs. Given our size, we’re often able to negotiate better terms for our investors. These often take the form of lower fees, lower minimums, or preferred access (e.g., guaranteed capacity in existing or future funds). Additionally, we’re often able to negotiate lower administrative fees for our funds. For example, we’ve capped the administrative expenses for Aspen Partners funds at 0.19% of aggregate committed capital, which is well below industry averages.
- Simplified administration. Investing in private markets can be confusing and complex.Subscription documents, private offering memoranda, limited partnership agreements, K-1s, estimated taxes, and more — the list of complicated legal documents and requirements goes on and on. To help our advisors and clients navigate all this complexity, we’ve streamlined the process through the establishment of a dedicated Private Markets Service Team. This team works in partnership with advisors and clients to collect and coordinate the completion of all required paperwork and deliver a good investment experience.
Private investments will undoubtedly continue to rise in popularity in the years ahead. And while we believe private investments offer investors opportunities for improved diversification and better returns, these investments are certainly not without risk.
Providing clients a balanced picture of the risks and opportunities that private investments offer is a key part of our role as fiduciaries. We don’t invest in private markets believing they’re risk-free, but we’ve developed a careful approach that, in our experience, best positions our clients to capture the benefits of private investments while at the same time carefully managing and considering their risks.
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Mercer Advisors Inc. is a parent company of Mercer Global Advisors Inc. and is not involved with investment services. Mercer Global Advisors Inc. (“Mercer Advisors”) is registered as an investment advisor with the SEC. The firm only transacts business in states where it is properly registered or is excluded or exempted from registration requirements.
Aspen Partners is a series of private markets funds managed by Mercer Advisors Private Asset Management, Inc. a SEC registered investment adviser and affiliate of Mercer Global Advisors, Inc. No fund management fee is incurred for Mercer Advisors’ clients, excluding underlying manager fees. The management fee is 1.5% per annum for investors who are not clients of Mercer Global Advisors, Inc. Fund terms are subject to change. Investing in private funds is speculative and will entail substantial risks.
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