Why ‘Throwing Darts’ in Private Markets Isn’t Enough

Once the exclusive playground of the wealthy, private markets are now the hot area of interest for financial advisors.

The appeal is multifaceted, with a heavy focus on the benefits of diversification and performance beyond the broad market stock and bond allocations that dominate most retail and mass-affluent investor portfolios. But there are also issues, specifically around suitability and liquidity, that advisors need to consider before jumping in.

Historically, the theory behind them is that they’re not perfectly correlated with public debt and equity, said John Clark, founder of Wolf Bay Wealth Partners. “By adding private assets into a portfolio, investors can achieve higher returns, or lower risks, relative to their original attainable frontier,” he added. “But much of this return has been driven by a market premium for purchasing illiquid assets.”

We’re On a Liquid Diet

One of the more pressing considerations is reduced liquidity, especially when compared to something like an exchange-traded fund that can be traded throughout the day. That’s true when allocating client assets to funds investing in areas such as private equity, private credit, venture capital and real estate. Another factor is the fees, which can be multi-layered and often combine management and performance charges. But proponents say the tradeoffs of less liquidity and higher fees make sense for certain clients.

Blair Cohen, managing partner at GoalVest Venture Capital, helped the registered investment advisory firm launch its first venture capital fund in 2022 as a way to offer clients access to the private markets. “Over the past 20 years, the number of publicly traded companies has gone down by half,” he said. “We found that the opportunities from traditional public markets just aren’t as appealing, because the markets are more mature and concentrated.”

GoalVest is now on its second fund that invests in private companies between two and four years from going public or being acquired.

While Cohen said the VC funds are targeting returns in the 20% to 30% range, he admits they are not for everyone. “Our funds have a 7-year lifespan and there are no redemptions during the time,” he said.

Build It, They Will Come. Chuck Failla, founder and chief executive of Sovereign Financial Group, is also wading into the private investments market by building his own funds. “As an advisor, I want exposure to a diversified basket of alternatives, like private credit, private equity and real estate,” he said. 

Sovereign’s Align Alternative Access Fund is a non-traded registered fund of funds with 21 underlying positions across 14 funds. The fund charges 50 basis points on top of the fees charged by the underlying funds, which Sovereign caps at 95 basis points. “The underlying funds are not cheap, but the performance justifies the fees,” Failla said. Like Cohen, Failla limits exposure to alternatives in client portfolios to between 20% and 30% of the money invested for the long term. 

Don’t Throw Darts

While suitability is always a factor that advisors must consider, investing in private markets introduces the question of how much illiquidity clients can handle. “After understanding the client’s appetite for illiquidity, it’s important for advisors to be mindful of the risks related to the opportunity and be able to clearly communicate those to the client,” said Ben Sayer, alternative investments group head and managing director at MAI Capital Management.

“We believe that private markets can add benefits to a portfolio in both expected returns and diversification, but that doesn’t mean that every private opportunity will be a good investment or additive to a portfolio,” he added. “The dispersion between good investments and bad investments in private markets is very wide, so investment selection is key.”

The performance dispersion is what makes due diligence on private markets a “full-time job,” according to Jake Miller, co-founder and chief solutions officer at Opto Investments. The stakes can be a lot higher when dealing with private assets: 

• The difference between top- and bottom-quartile, long-short managers is 4% to 6%. 
• With private equity and venture capital, the disparity is more than 20%.

“This speaks to a key risk advisors need to keep in mind,” Miller said. Unlike the long-only equity markets where an advisor can pay a few basis points for an ETF offering exposure to the entire market, he said, private markets have “no investable index, and the range of outcomes is high.”

“You should have a diligence process in place that makes you confident that, a high percentage of the time, you can avoid allocating to bottom-quartile managers, and ideally can consistently allocate to top-quartile managers,” he said. “Just throwing darts in private markets isn’t sufficient.”

What’s the Worst That Can Happen? Paul Schatz, founder and president of Heritage Capital, views the growing popularity of private markets investing as a reason to avoid the space.

“I think private investing is overdone with too many assets flowing into the space,” he said. “And what is promised in the private markets often diverges from what is delivered.”

Schatz reflects on the financial crisis of 2007 when nontraded REITs collapsed along with the real estate market, and investors were prohibited from cashing out as prices were falling. “I am not a proponent of private investing for the general investing public, and I don’t recommend it,” he said. “Many folks only see the upside and ignore the consequences.”

When it comes to due diligence, Stephen Tuckwood, director of investments at Modern Wealth Management, said no corners can be cut.

“Ensuring that the liquidity terms of the vehicle align with the underlying assets is critical, as a mismatch can create problems,” he said. Advisors should review the manager’s experience and strategy, and consider worst-case scenarios first. Next, evaluate whether the investment still makes sense within the broader portfolio, he added.

Eat Your Evergreens. For advisors who are brand new to private markets investing, Craig Robson, founding principal and managing director at Regent Peak Wealth Advisors, recommends diversified exposure through “perpetual or evergreen strategies as a good starting point.”

Focus on a comprehensive approach that includes various types of private investments, such as private equity, private real estate, venture capital, commodities and private credit, which can mitigate the risk of selecting one niche area that may be in favor now but not in the future, he said. “The percentage allocated to one’s respective risk profile should be large enough to statistically provide portfolio differentiation over time.”