The pitfalls of private assets
Understanding the risks behind the returns
For much of the modern investment era, capital markets were dominated by public markets. Companies raised equity on stock exchanges, governments and corporations issued publicly traded bonds, and investors built portfolios primarily from listed securities.
That is now outdated. Over the past two decades, a vast amount of investment activity has taken place on private markets. Private equity, private credit, venture capital, infrastructure, and other unlisted assets now represent substantial components of institutional portfolios. What’s more, retail investors are also gaining greater access to private assets.
Private markets have moved decisively from the margins of finance towards its center. This profound change in global capital markets—and potentially a major opportunity.
Yet, whenever an asset class becomes exceptionally fashionable and capital follows, investors should ask not only what returns it has generated in the past, but what risks they are accepting.
Key Takeaways
- Private markets have moved from the margins to the mainstream. Private equity, credit, venture capital, and infrastructure are now core to institutional portfolios, with retail investors close behind.
- Higher returns come with hidden costs, the illiquidity premium is real, but so are the risks: long lock-ups, leverage, complexity, and valuations that can mask true volatility.
- Smooth is not equal to safe. Infrequent, model-based pricing can make private assets look less risky than they are. A stable price and an unobserved price are not the same thing.
- Success now depends on selection, as capital floods in, the gap between the best and worst managers widens. The real question isn’t whether to invest, but where, how, and with whom.
In this article
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Institutional appetite for private assets
Several factors explain institutional investors’ growing enthusiasm for private assets.
Primary among these is the prospect of enhanced returns: investors have historically received what is known as an illiquidity premium for committing capital for long periods.
Diversification is another attraction. Private assets are not necessarily correlated with listed equities and bonds.
Institutions such as pension funds have long investment horizons. A pension fund with liabilities stretching decades into the future does not necessarily require every investment to be immediately tradable. This means that private markets can provide a natural match between long-duration assets and long-duration liabilities.
Private assets and valuation smoothing
Public markets valuations are both transparent and timely (a listed company’s share price can change every second).
Private assets are different. Because they may trade only occasionally, valuations are generally estimated periodically using financial models, comparable transactions, and professional judgment. Consequently, a privately owned company may appear considerably less volatile than a comparable listed company, with valuations typically being made quarterly.
Where underlying economic volatility is understated, this can make private investments appear less risky than they actually are. Investors therefore need to distinguish between an asset whose price is stable and an asset whose price is simply observed infrequently.
The price of illiquidity
Liquidity presents an equally important challenge.
Traditional private equity funds may lock up investors’ capital for ten years or longer. Infrastructure investments can have even longer horizons.
But, if and when investors require cash unexpectedly, or when distributions from existing investments slow just as commitments to new funds require additional capital, lack of liquidity can be fatal, a factor particularly important for the growing cohort of retail investors.
The fact of making an illiquid asset available through a fund offering periodic liquidity does not make the underlying asset liquid.
Private markets and increased regulatory attention
The rapid expansion of private markets has inevitably attracted greater regulatory scrutiny.
Particular concerns include leverage, valuation practices, transparency, conflicts of interest, and connections between private funds and the banking system. The IMF has noted the growing importance and interconnectedness of non-bank financial institutions engaged in private markets trading which has the potential to amplify financial shocks.
Opportunity or bubble?
The impressive returns generated by private assets has led to suggestions of an investment bubble but this is probably too simplistic.
Private equity, private credit, infrastructure, and venture capital perform genuine economic functions. They finance businesses, innovation, and infrastructure while providing investors with opportunities unavailable through traditional public markets. For these reasons, their long-term expansion seems likely to continue.
But higher returns generally only exist in private markets because investors accept additional risks: illiquidity, leverage, complexity, valuation uncertainty, and greater dependence on manager skill.
Furthermore, as more money enters private markets, excess returns may become harder to achieve. Too much capital pursuing too few attractive investments inevitably push acquisition prices higher and depress future returns.
The implication of this is that manager selection will become increasingly important. By tracking a public market index, investors can cheaply obtain the market return, but performance dispersion between successful and unsuccessful private-market managers can be substantial.
The next stage in the development of private markets may therefore be less about whether investors should participate and more about where, how, and with whom they invest.
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Frequently Asked Questions
What are private assets and why have they become more important?
Private assets include private equity, private credit, venture capital, infrastructure, and other investments that are not publicly listed. Over the past two decades, these assets have become increasingly important within institutional portfolios as investment activity has expanded beyond traditional public equity and bond markets. Their growth reflects both the opportunities they offer and investors' willingness to accept additional risks.
Why do institutional investors allocate to private assets?
Institutional investors are attracted to private assets for several reasons, including the potential for enhanced returns, diversification, and the illiquidity premium associated with committing capital for long periods. Pension funds and similar institutions may also find private assets suitable because their liabilities can extend decades into the future, allowing them to match long-duration investments with long-duration obligations.
Why can private assets appear less volatile than public assets?
Private assets may appear less volatile because they are valued less frequently than publicly traded securities. While listed share prices can change continuously, private asset valuations are generally estimated periodically using financial models, comparable transactions, and professional judgment. This can smooth reported valuations and understate underlying economic volatility, making an investment appear more stable simply because its price is observed less often.
What liquidity risks come with private assets?
Private assets can involve long periods during which investors cannot easily access their capital. Traditional private equity funds may lock up money for ten years or longer, while infrastructure investments can have even longer horizons. Liquidity becomes a particular concern when investors unexpectedly need cash or when distributions slow while new commitments still require funding. Periodic fund liquidity does not make the underlying asset itself liquid.
Why are regulators paying more attention to private markets?
Regulators are paying closer attention to private markets because of their rapid expansion and increasing connections with the wider financial system. Areas of concern include leverage, valuation practices, transparency, conflicts of interest, and links between private funds and banks. The growing importance and interconnectedness of non-bank financial institutions involved in private markets may also increase the potential for financial shocks to spread more widely.
Are private assets in a bubble, and what should investors consider?
Describing private assets as a bubble may be too simplistic because private equity, private credit, infrastructure, and venture capital perform genuine economic functions. However, higher returns generally come with additional risks, including illiquidity, leverage, complexity, valuation uncertainty, and greater dependence on manager skill. As more capital enters private markets, attractive opportunities may become harder to find, making investment selection and manager selection increasingly important.
Private markets can offer diversification and return potential, but they also bring risks around liquidity, valuation, leverage, and manager selection. Intuition helps financial services teams build the capital markets knowledge needed to understand these risks and make informed investment decisions. Fill out the form below to discuss your learning priorities.
