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The days when private markets were the purview of only institutional investors and high-net-worth individuals (HNWI) are ending. A whopping 97% of asset management professionals report strong or moderate retail interest in private markets, according to a survey by Apex Group, a global financial services provider.
This surging interest is being met by improved access. Regulatory reforms and initiatives by industry players are two factors behind this congruence, according to Norton Rose Fulbright, a global law firm.
Nevertheless, many retail investors do not fully understand how private markets (and assets) differ from public markets (and assets). While lured by the potential for higher returns and diversification benefits, they neglect ongoing problems like regulatory limitations, high investment thresholds, and liquidity concerns, as Apex Group noted.
As a financial advisor, it is your responsibility to bring clarity and balance by helping your clients understand the challenges of private markets and how they can navigate them.
Key Takeaways
- including long lock-up periods, unpredictable capital calls, and illiquidity risks.
- Though investors can sell their stake in secondary markets, they must do so at a discount. Also, there are valuation issues resulting from net asset value (NAV) being calculated quarterly rather than daily.
- Also, though semi-liquid funds allow redemptions, they can be done only quarterly or semi-annually, and the amount that can be redeemed is capped.
- Given the risk-reward characteristics of private markets, a long-term perspective is essential. Financial advisors should help their clients understand that private market investments suit investors who can commit capital for 5–10 years, accept delayed liquidity, and balance risks with potential rewards.
How Private Markets Operate
A knowledge of how private markets operate is the first step towards a clear grasp of the challenges they bring to investors. To understand private markets, consider the five key stages of the life cycle of private market funds:
Stage 1: Fundraising and Commitment
Investors commit a certain amount to the fund. There will be a contractual agreement establishing the commitment. However, no cash is transferred at this stage.
Stage 2: Capital Calls
When investment opportunities arise, the fund’s general partner (manager) starts making capital calls. A capital call is a request for a certain percentage of the commitment to be transferred in.
For example, if Investor A commits $10 million, a 10% capital call will require her to send $1 million to the fund. The general partner will make such calls once a year for a given number of years until all the committed amounts have been transferred in.
Warning
Capital calls are unpredictable. Investors may not have more than a 10–15-day notice to send money in.
To meet these sudden calls, many investors must set aside cash (usually the entire amount committed) that they can quickly access. To guarantee this quick access, the cash must be put where it generates little to no interest. Otherwise, investors must borrow or liquidate assets to meet capital calls. These can be inefficient if the interest rate is high or if assets are liquidated at a loss.
Stage 3: Investment and Value Creation
At this stage, the fund deploys the cash accumulated into private assets, allowing it to grow.
Most of your clients are used to the world of stocks, bonds, and ETFs, where they can enter and exit a trade in minutes, depending on the effectiveness of the stockbroker.
Things are a bit different in private markets. Here, investors are required to have longer hold periods.
Note
Of course, there are retail investors in public markets who also have long hold periods. Thus, a long hold period can’t be a differentiating factor.
Understanding Lock-up Periods
The important thing to note is the word “required.”
There is a mandatory lock-up period during which investors in private market funds cannot liquidate their holdings (partially or in full). This can be up to 1-3 years for hedge funds, 3-7 years for private credit, 5-10 years for real assets (infrastructure, real estate), and 8-12 years for venture capital.
Private market funds often require a lock-up period due to the very nature of private assets.
- Private assets are illiquid—there is no public exchange where they can easily be bought or sold.
- The nature of these assets requires a long-term strategy. It takes time for a private company receiving private equity or venture capital to grow and become profitable. Similarly, infrastructure projects take time to execute.
- Given the first two factors, fund managers need stable capital that they can patiently deploy without worrying about redemptions or withdrawals.
Stage 4: Distribution
As the private assets in the portfolio are sold or recapitalized, the fund gathers some proceeds. These proceeds are distributed to investors.
In most cases, distributions start after the last capital call has been made, but there are cases where capital calls are made after distributions begin.
Stage 5: Final Exit
The remaining assets of the fund are sold, and the proceeds are distributed to the investors. This marks the end of the lock-up period.
Example of a Call-and-Distribution cycle
Let’s take an example of a private equity fund to illustrate these stages.
Suppose Investor A commits $10 million to the XYZ Private Equity Fund. The fund has a 10-year lock-up period.
The capital calls for years 1, 2, 3, and 4 are $2 million, $3 million, $2 million, and $1 million, respectively.
At the beginning of year 2, the general partner starts deploying the capital. This happens consistently until year 6.
By year 5, the GP started exiting some assets, so distributions started. Distributions for years 5, 6, 7, and 8 are $1.5 million, $2.5 million, $3 million, and $2 million, respectively.
Between the ninth and 10th years, the fund winds down, selling all remaining assets. Investor A gets a final $1.5 million.
What “Illiquidity” Really Means in Private Markets
Lock-up Period and Illiquidity
As we have seen, there is a lock-up period during which investors cannot redeem their capital commitment. This is the first reason for the illiquidity of private markets. Also, we have seen that this lock-up period is a product of the very nature of private assets and private market investment.
Does it then mean that investors cannot sell their stake at all? Not at all.
Secondary Markets and Illiquidity
They can sell their shares in a private secondary market. This is a market for the purchase and sale of commitments to private market funds.
Suppose Investor A had already answered the first capital call of $2 million. She can decide to sell off the remaining commitments. The buyer (Investor B) will now be responsible for committing the remaining amount (potentially $8 million). Since Investor A already has a $2 million stake in the fund, Investor B will pay for this stake and take it over.
If such a market exists, why are private markets still considered illiquid? Well, there are a few reasons.
- Investor A can only sell that $2 million stake at a discount. In this case, she may only get $1.8 million.
- Since they are not traded on public exchanges, the price discovery process in private markets is inefficient.
Private market funds report NAV quarterly (in keeping with the long-term nature of private market investing).
This means that at any point in time, the NAV does not reflect current market conditions. In other words, there is no way for investors to know the value of the fund (and its underlying assets) in real time. Thus, at any time, the fund can be overvalued or undervalued.
One result of this is that investors who want to sell in secondary markets may end up doing so at a premium or discount to what would have been the actual NAV at the time of the deal. For example, if the NAV is $2 million but should have been $2.2 million if the NAV were recalculated every day, then there is an inherent $200,000 discount.
If Investor B pays $1.8 million, then Investor A is selling at a $400,000 discount (what we can call a double discount).
Finally, there are legal and administrative hurdles that may result in secondary market deals taking months to complete.
Can Semi-Liquid Private Funds Help?
Semi-liquid private funds are the bridge between traditional private market funds (closed-end private funds) and public markets.
They allow investors to redeem a portion of their investment periodically, usually quarterly. Also, investors typically make a single upfront payment instead of multi-year capital calls.
To support these periodic redemptions, the fund will hold some money in cash or public market assets. This ensures they are not under pressure to sell illiquid assets for a discount on the secondary market.
However, semi-liquid private funds also face the same NAV drag issue as their closed-end counterparts. At any time, an investor is redeeming a portion of their stake, the NAV is either undervalued or overvalued.
When Liquidity Does Come (and How)
Though illiquidity remains a challenge of private market investing, it is not a permanent problem. Investors can still get liquidity returned to them at different stages of the private fund’s lifecycle.
We consider four ways liquidity comes and when:
1. Liquidity Through Redemptions in Semi-Liquid Funds
Though semi-liquid funds also have an initial lock-up period, it is often very short (around 12 months).
Once this period elapses, investors can submit redemption requests during scheduled redemption windows. As we said above, these redemptions are capped (as a % of the NAV), and they are usually available only quarterly or semi-annually.
Also, investors must give advance notice of one to three months if they plan to redeem at any of the redemption windows.
2. Liquidity Through Distributions
Investors in closed-end funds will only start receiving liquidity when distributions start. In some funds, this may not happen until the fifth year. It all depends on when the fund manager starts exiting some positions in the portfolio.
3. Liquidity Through Sale in Secondary Markets
Investors in closed-end funds who can’t wait can sell their stake in the secondary market. This is another way to receive liquidity. Sale in the secondary market can occur at any time during the fund’s lifecycle.
However, we have seen that investors can only sell in this market at a discounted price. The presence of a NAV lag can also make the sale less appealing.
4. Liquidity at Exit Point
For both open-end and closed-end funds, liquidity comes during the final exit period of the fund. Here, the fund liquidates all remaining investments and shares the proceeds to all investors.
Tips for Framing the Conversation
Given all we have said, you must provide a balanced view to your clients when evaluating private markets.
Discuss Their Goals
Since private market investing requires a long-term perspective, you should have a frank discussion about your clients’ goals. This will help you determine if their goals can cope with the illiquidity of private markets.
Highlight the Benefits
However, while we have focused on the downsides of private market investing, it is important not to skew the conversation. You should also reinforce benefits like higher returns and broader diversification, among others.
Be Transparent About Risks
Nevertheless, you must accompany a reinforcement of benefits with transparency about risks. As we have seen, illiquidity is a key risk factor. The unpredictable nature of capital calls, and how they can impede cash flow planning, and the impact of NAV lags on pricing are others.
Tip
You can also mention the limited regulations of private funds and how this leads to insufficient disclosures, making it difficult to assess both risks and performance. Macroeconomic and political shifts can also affect the profitability of private companies as well as infrastructure and real estate projects.
Emphasize the Need for a Long-Term Perspective
Yes, the returns are usually higher than what’s available in public markets, but can they manage the long-term investment horizon it requires?
Help them understand that this is not where they can put money, they will need in the next 5–10 years, that it is more like planting trees rather than trading stocks.
Also, emphasize that this long-term perspective is a consequence of the nature of private assets themselves. “No matter how great the talent or efforts, some things just take time,” said Warren Buffett. “You can’t produce a baby in one month by getting nine women pregnant.” Infrastructure and real estate projects take time, and young companies take time to become profitable.
This conversation should be easier with investors who already operate with a long-term horizon.
Illiquidity and the Semi-Liquid Option
You can also broach the idea of semi-liquid private funds to those who are concerned about liquidity.
However, clarify that this is not a comprehensive solution. Redemptions are limited (usually quarterly or semi-annually), subject to caps, and can be suspended if the general partner has good reasons to do so.
Furthermore, valuation challenges remain, and these funds can be more complex to operate, leading to higher fees.
What Is a Lock-up Period in Private Market Investing?
A lock-up period is the mandatory timeframe during which investors in private market funds cannot redeem their capital, either partially or fully. Depending on the asset type, lock-up periods can range from 1–3 years for hedge funds to as long as 8–12 years for venture capital funds.
Can Clients Access Their Money Early?
Yes, but options are limited.
Investors may sell their stake in a private fund through secondary markets, though this often requires accepting a discount and navigating slow, complex transactions.
Some semi-liquid private funds offer quarterly or semi-annual redemption windows, but these redemptions are capped, require advance notice, and can be suspended by the fund manager.
How Are Private Investments Valued?
Private investments are typically valued using net asset value (NAV) calculations reported quarterly. Because these valuations are infrequent and based on estimates rather than real-time market pricing, they may lag current market conditions.
What’s a Capital Call?
A capital call is a request from a private fund’s general partner for investors to transfer a portion of their committed investment into the fund. Capital calls occur when the fund identifies an investment opportunity and can be unpredictable, sometimes providing only 10–15 days’ notice.
The Bottom Line
Your role as a financial advisor is to help your clients understand the risks and rewards of private market investing. This includes providing a foundation in how private market funds operate, including features like lock-up periods that may last years.
Above all, ensure that your clients are prepared to invest for the long haul. Private market investing is about long-term value creation, not near-term liquidity.
