Do Private Markets Deliver an Edge?

Should I be investing in private assets? That is our topic today on "Informed Investor." And it's also a continuation from a conversation we had around investor protection. Joining me for the conversation today is Jake DeKinder and Dr. Wes Crill. And we are wound up today. We're fired up for this topic. I mean, I'm normally fired up when we come in here, but I really do because we are getting a lot of questions over the last couple of years on this. So I think this one will be good to sort of unpack what do you need to know about those markets. Let's start with a couple of headlines here as it applies to private assets. First one, "The Gilded Age of Private Equity for the Masses." The second one, "The Risky World of Private Assets Opens Up to Retail Investors." Now, there's one other one I wanted to highlight here, and this one just came out in the last days. Hot off the press. Hot off the press. Super, super interesting one here. And some of the content in this one. "Are You Smart Enough to Invest in Private Assets?" And this is something, you found this article, Jake. It popped up this morning. And some really interesting things in here when it comes to, I'll say, knowledge investors have when it comes to just general investing. Well, one of the things that was interesting in there is there was a study run by FINRA, regulatory body within our industry there, and it was the Investor Education Foundation that put this out. They basically designed a short study, seven questions, they put it out to 25,000 investors. This was a couple of years ago. And we went through and actually, took the test. I mean, they're reasonably basic questions. These were interesting stats. Only 4% of people got all seven correct, seven out of seven. Less than half got four out of seven. And I'll give you a taste on what these questions were. One of the questions was around if interest rates go up, what happens to bond prices? And 42% did not know. And 33% got it incorrect. And, Mark, you get all these correct, right? I figured that's why you said you were fired up as you passed the test. Let's be clear, you said we took the test. I took the test. With us watching you- And you were behind me watching, and I had total pressure of the two of you going, "Okay, am I gonna get it right? Am I getting it right?" Fortunately, I got all seven right. I am part of that 4%. Good job. Whew! Stressful. But yes, some of the questions were like that about, yeah, how do bond prices move, depending on what happens with interest rates. One of them was, if I have $1,000 in a savings account and I have a 1% interest rate and inflation is 2%, does that mean my money's gonna be worth more or less or the same, or I don't know? So interesting questions there. And again, I go back to that's why we're doing the show, just trying to bring some insights, some information to investors, depending on all these things out there, so you can make the best decision you can make when it comes to your money. Yeah. Anyway, let's bring it back to the topic, and let's get some definitions here because we've already thrown a couple different terms out. We've talked about private equity on here, the headlines, private assets. So let's set it up. Now, I wanna go at a higher level, and you hear about this out there in the industry, alternatives. And what exactly are alternatives? And so let's just separate that from private assets. So a lot of times we hear alternatives. It might be things like real estate, it might be things like commodities, or even hedge funds. So something different than publicly traded stocks and bonds. Anything you guys would add to that when we thinking about alternatives? Yeah, I mean I think that's a generic definition. Just the idea of alternatives, which is something that's outside of the scope of publicly traded assets, like stocks, bonds, REITs, and things like that. In private market, investing, I think of, as being a subset of that. And as a name suggests, I mean these things that are not publicly traded. These are in private markets. I mean, I think that's where some of the allure comes into play, right? Because if it sounds private, it sounds like, "Ooh, there is a mystique associated with it that not just anyone can access these things." And I think that's where the evaluation comes into play. Well, you're spot on with the allure. I mean, I was gonna say the exact same thing. It's sort of like it's a, we said this a couple of times, I think there's a lot of things that are kind of marketed in this industry and designed to create this either allure, this fear of missing out, this, "I want access to the stuff that the masses don't have access to." And I think as we start to talk about private assets and private investments, there's definitely that element of it. You hear some of these companies that have been started up and have done phenomenally well. And you think, "Well, a lot of these companies have that experience, not necessarily that's always gonna be the case here." So let's get into how do we think about private assets or private equity. We'll probably use those terms throughout the conversation here today. But we go back to a prior episode, and I think it's a really important one to reflect on, where we talked about a framework to use when you're considering any investment out there, whether it's stocks or bonds or private assets. And so I wanna highlight the major categories there of this framework, and then we'll kind of get into each one of those and apply it to private assets. So four things there we talked about. One is what's the goal? What you're trying to accomplish? What's your expected return, or the return you're gonna get over time from that particular investment? What are the risks associated with that investment? And then what are the costs? So let's dive into that and think about how private assets sort of fits in with each one of these buckets. And, Wes, I'll start with you. Let's just start with the goal we often hear about what private equity can bring or private assets can bring to an investment experience. I mean, I think it's usually pretty simple. It's often twofold. It's either they're trying to increase the return of their portfolio. They believe that private market investing, whether it's private equity, private debt, or private real estate, maybe offers a source of untapped returns for their portfolio. Or they're looking for something they think might manage a risk. And I think that's maybe the interesting aspect of it. Whether it's broadening their diversification, giving them something access so they're not able to get in a publicly traded portfolio, maybe even something they perceive to be uncorrelated with public markets. We can delve into whether that's strictly true or not. But I think those are the main kind of goals that people would look to when it comes to private market investments. Go into the uncorrelated piece, 'cause I hear that one a lot, which is, "Oh, it's a diversifier. Oh, it's uncorrelated with other parts of my portfolio or it's uncorrelated with public markets." Yeah, when people talk about adding diversification to their portfolio, one of the ways they might try and measure it is using the correlation, the extent to which the returns of an asset move with the returns of the rest of their portfolio. That's very challenging with private market assets because as a name suggests, you know, these are in private markets, they're not trading as frequently as public markets. And so because of that, you can have asset values for the investments of these strategies that are maybe stale, they're lagged, maybe they're being smooth in some cases. You know, you can compare it to, like for example, if you were trying to buy a home in a neighborhood where there's very few transactions taking place on a regular basis, it might be hard to figure out what is the current market value of those homes because there hasn't been a transaction that you can appeal to in recent periods. And so the way that shows up in the returns is those returns might not be moving at the same time as an asset. It doesn't mean the values of those assets haven't changed. It might mean they're not being marked to market because there's not a transaction taking place. So if you have two things that are not moving together, it becomes very difficult to measure a correlation there and, you know, it's probably not gonna be very meaningful. Then that means estimating the diversification benefit through that method might not yield meaningful results. Let's go back to that idea of mark to market. So here's how I think about that, that kind of discussion, what you just laid out there. Let's say you have a building, it's on a corner. Let's just say it's a seven-story building worth $10 million. Right across the street is also a seven-story building, and let's say it's worth $10 million, It purchased both of 'em at the same time. So in a, let's call it a publicly traded security, that building on the right side of the street, that's getting marked to market every day. Meaning, the market is putting what they perceive the value to be at that given time, reflecting everything that's happened. It could be a change in interest rates, it could be a recession, what's going on in the economy, all these different things. So that price is moving every single day. Yet, the building on the left side of the street, there is no mark to market that day. And so it sort of stays at that level. And that's where you're talking about this smoothing of, the price isn't changing. So it looks like that investment might just have a much smoother experience. But the reality is everything that's happening in society, it's impacting that price too. If they were to go to sell it, it's just not being shown up necessarily in day-to-day returns. That's kind of where you're going with that? It is. And I mean, it's analogous to, if you're holding a bond to maturity and interest rates change, going back to that quiz question earlier, it's not that the value of that bond is not changing, it's just that if you haven't sold it, you haven't realized whatever the impact is on its price. Well, and I think part of the challenge of coming up with that price every single day is simply the amount of buyers and sellers that are there, right? I mean, in your example, for your $10 million office building, like, yeah, there are buyers and sellers for that. But you contrast that with something like public markets where we know the trading volume there of literally like millions of people coming together every single day, hundreds of billions of dollars changing hands. It makes sense that you can get a market price. It's just you have two different markets there when you think about supply and demand, buyers and sellers, and the ability to almost come up with a price daily. I'm gonna throw another idea out there for why people buy private assets and going back to what's the goal? I think sometimes just to have some fun. It could be cool. Yeah.- Hey, why don't you go buy some startup companies and just see how that goes. And so that could be another reason as well just to have a little fun along the way on those things. Well, in expanding your opportunity set. So if we talk about the challenges to measuring diversification, one way you could appeal to that is, is this offering something that I'm truly not able to get somewhere else? And that is the case with private markets, right? These are assets that are literally not in a public market portfolio. So then the question is, how much more are you getting? And then, you know, what are sort of the considerations that come along with that expansion of the opportunity set? I mean, it's hard to get an exact number on this, but it does appear that the private market segment is substantially smaller. Maybe an order of magnitude smaller than public markets. And so maybe it's not a huge amount that you're adding to your portfolio, but it's not nothing. But then you think about what's the other side of this? Well, it doesn't necessarily mean you're getting more diversification 'cause you think about the underlying investments for private markets might be concentrated, it might only have a few assets within the portfolio. And so you might be bringing on this idiosyncratic component of volatility at the same time as you expand your opportunity set. And it's not totally clear that that's a net benefit for diversification. I think it's interesting on the numbers in private markets too, when you try to get a sense on how big it is, and to your point, it's a real challenge. I think there's a lot of businesses out there. So sometimes you see numbers that are quoted in terms of here's the opportunity set, but when you really kind of dig in and unpack it, it may even be smaller than that. Hey, you go back to what you just said there. I want to just make sure we clarify a couple things. So you talking about, you know, maybe it's a concentrated holding, so you might have a private equity fund. Now within that fund, there might be, say, five companies, or two companies. Is that what you mean about it could be potentially concentrated? Yeah, exactly. Yeah, it's, you know, different than in public equity markets, where you have maybe 12,000 stocks in one global allocation. This might only be a handful of assets or handful of businesses in which they're investing. And so, you know, that's sort of the trade off when you talk about, okay, you're adding something to your portfolio, but it itself might be relatively concentrated. All right, let's talk a little bit about returns. So we talk about the stock market, and you go back 90 plus years, and that annualized return of that time period is right around 10%. How do I think about an expected return in private markets Because of this lack of the reporting requirements for private managers, it's harder to get really an unbiased estimate of what their performance is. But we've looked at the data around that, and there's two aspects that are interesting of it. One is just to find what has been the average return for these managers. But really, it's the range of outcomes that I think are gonna be most relevant for investors. There's truly huge return dispersion. So, yeah, if you're in the top quartile of these managers, may be a great experience, whether it's private equity, private debt, private real estate. But because of that range of outcomes, if you're in the bottom quartile, that could be a pretty rough run. We've done a lot of research around that. And just by that, you just mean hey the outcomes are so far over here on the right side, meaning very good. It could be way over here, way on the low side. 'Cause a lot of these companies, none of 'em survive. And you probably have everything in the middle there. That's what you mean by dispersion? Exactly. And then it's, okay, well, how do I determine whether a manager is going to be in the top quartile going forward? And that's where, you know, you have to have an evaluation process. Again, it might not be a systematic type of approach that you can appeal to. It might be something where you have to do your due diligence on this. And so that brings up a whole nother question of the resources that would need to be dedicated to evaluating these managers. Yeah, that's a good point On the resources. You know, you look at a lot of like the large institutions that are out there, big endowments fund, whatever it may be, right? I mean, a lot of times, they're gonna have teams that are dedicated. I mean, sophisticated, experienced professionals who are looking in this stuff all the time and doing due diligence, right? And even within the advisory space, you know, we'll talk to some firms. And I think firms that have actually done a pretty good job of operating within the private markets. And you ask 'em, and a lot of times they have dedicated professionals, dedicated teams to this. So then you put that back on yourself as an investor and think about what's gonna be the required due diligence so that I feel comfortable going into those markets. And it can be a lot, it can be a really big burden. And so then you have to ask yourself, "Is that trade off worth it and what am I really getting for going into those markets?" Yeah. And the NACUBO study that we look at sometimes for the performance of endowment showed that the bigger ones tended to do better than the smaller ones. And that could be attributable to, they have more resources to dedicate towards evaluating these private market investments so they can get better returns from them. That also comes down to access to the deals as well, right? Yeah. And again, we're not here to say, like, these are good and bad. We're not here to say you're gonna have a disastrous experience, right? These are just logical things you gotta think about as you start to move into that space. Yeah. Can I as an individual investor get the same access to some of these top tier managers than sovereign wealth funds you talked about earlier? Yeah. All right, so on the expected return, it's just hard to, it's hard to really know exactly to come up with an expected return framework just because we don't really have the data, like we do in public markets. But let's talk about the risk side of things a little bit. Jake, I'd love to get your thoughts as we think through this. You talked about doing the due diligence. What are the areas we have to do some due diligence and when we think about private markets? Well, it's a great question. I mean, do you understand the manager? What's their experience? How much insight do you have into the deals they're going into? Or are you sometimes, are you just giving money to a manager and then they're gonna figure out where they put that money to work, right? I mean you also have to appreciate that as you start to go towards these private, I mean, just think about it, right? What are the stats on how many businesses go that fail in the U.S. right? And that's a good mindset to say that as we go into this, right? There can be great returns, but there's plenty of stories, there's plenty of examples. And I think, intuitively, people understand that yeah, businesses go out. And so when you're investing in private equity, to an extent, you kind of want to think about that of you can have a home run, it can go really well, but you can lose a lot of money and you have to be prepared for it. And that is also why a lot of these traditionally have been designed for accredited, sophisticated investors. And a lot of times, there is an income hurdle or an asset level that you need before you go into. I mean, that's kinda the way the system was set up. Now we are seeing some trends now where that's starting to come down a little bit. And I think those are some of the headlines you talked about about retail starting to go into it. But again, you just gotta be prepared for this, that yeah, you can do well, but these things can kind of blow up at times. Well, and to be clear, when you're talking about the headlines, retail, there's been conversations, proposals now, we're making private equity investments available in 401k plans. Yeah. Things like that, right? Right. More access- Let's getting out there. More liquidity. Yeah. Well, let's talk about, you mentioned liquidity just now, you know, how do we think about that as something from a risk perspective in terms of how long is my money tied up? How do I find out how long my money may or may not be tied up in something like that? I mean the traditional approach to this was your capital would be locked up really for a very long period of time as they made their investments in these businesses. And as they started to exit from their investments, you would get distributions. The more recent innovations have been around these so-called interval funds, where you can access liquidity at maybe, you know, multiple points during the calendar year. But even that's not a guarantee. And one of the challenges here is these things haven't been around long enough to really stress test them through difficult markets. So we don't know if you'll necessarily be able to access your funds from these. And so it's an open question of whether that's really solved the liquidity problem. You think about from a financial planning standpoint too. I mean, the reality is, is that stuff happens in people's lives, right? I mean, you can get sick, you can have an event, things can happen where you need money and you have to appreciate that, for whatever reason. If you had a large portion of your wealth that was tied up in one of these things, that accessing that and meeting your needs can be really tough to do. Whereas in public markets, I mean, obviously, in a retirement plan and all that, there's penalties and all that. But for the most part, like, you got basically daily liquidity if you need it. So just another thing to keep in mind as you go into these investments. I think about liquidity, I guess, in two areas. One is where you're describing, where I invest $1,000 into a private asset fund, well, I'm gonna probably get maybe that back in five to seven years, hopefully at a much higher level. So that's one area. The other one is just something happens in my life, where I need to get access to that $1,000. Yeah. Yeah, And I may or may not be able to, depending on the structure of the deal. So just make sure you absolutely know what type of that, the policies are around redeeming your money out of a particular fund. Okay. Any other risks come to mind as you think about private assets? There's always the element of cost, right? That's one of the things we always encourage people to evaluate when they're thinking about different investments. And the costs are likely to be more substantial for private market investments. You know, maybe an order of magnitude larger. And then of course there's also the opportunity cost, right? So you could be investing that money elsewhere, where maybe you have more transparency over what the structure is, what the investments are, more of a sense of what the expect to return and risk are gonna be. So I think those are the other two really big elements that are important to be comfortable with when you're making those trade offs. The cost one is a good point too, in that, you know, there's probably gonna be some type of stated fee on what the costs are gonna be, but also understand that some of the operating expenses and some other things in terms of running that fund or managing a property or all of those can be born by the investors. And it may not be the stated fee that you have, but that's gonna take away ultimately from your return. So you have to understand that as well. I think about taxes too. Now, there's taxes paid on stocks and bonds, there's gonna be taxes paid on income and capital gains on both stocks and bonds, as well as private markets. But just go back to the operational nature of taxes. So on publicly traded securities, you get a 1099 from your, the investors' custodian. For private markets, you usually get a K-1. So it's just a little more complex, little more, I'll say, a longer time period to get your K-1. You maybe have to file extensions. So just be aware of those kind of things too. It's additional operational complexity. Back to the resources questions. Like, it's another thing to be on top of. It's not at the end of the world, right? But it's something to be cognizant of when you're thinking about whether this investment is for me. Well, it goes back to like, why are you wanting to hold it, right? And if you're really saying, "Okay, I have an objective in terms of how I wanna retire, what I wanna do for my kids," all of these things. You wanna think about, "I wanna achieve those returns." And in my opinion, you want to think about doing that where possible in a very straightforward, relatively simple way, if that is an option. And what we're talking about here is, now we're talking about more due diligence, we're talking about more tax reporting that may come in, getting all those documents together. Delays of K-1s. Anybody who's been in a private investment knows be prepared for a delay of that K-1. You're gonna get that email, right? It happens. So again, you just like eyes wide open of what am I trying to accomplish and what's the way I can move towards that? The last thing I wanna highlight too, as a consideration, is I think for a lot of investors out there, they may already have some sort of ownership in a private company. So for example, I think about that here for us at Dimensional, or a lot of our clients or financial advisors, where they own their own company. I mean, that's a private company. Completely. Right? So the question is, do you wanna overweight that in your portfolio if you already do have some sort of a exposure to a private asset or a private company? I think that's a good way to to think about it. 'Cause really, what are you saying, you're saying in terms of my overall wealth and maybe even in terms of my human capital, you could probably tie to some of that stuff in there, right, of how much exposure do I already have to private markets? And then, why do I need to do something different? And again, I wanna be real clear. We are not saying good or bad investment, right? It's just, it's a different beast. It be very clear on those different areas. Again, know your liquidity. Yeah. Know the fee structure. Know, probably, again, go back to I think the framework. Know the goals, exactly what you're trying to accomplish in investing there and the associated expected returns and costs. The 401k thing is gonna be interesting. I'm glad you brought that up. That to me is really gonna be interesting on how that's gonna work out. 'Cause traditionally, you have sort of the stock portfolio, the bond portfolio, target date funds, whatever, you know, things that people, I think, understand public markets relatively liquid. That's gonna be an interesting one to watch. We'll go back to your survey. So if 4% of people are getting all those questions right, you hope maybe those are the ones who are selecting private equity and their 401ks, but it might not be the case. Yeah. Yeah. Yeah, I do think that was an interesting survey. I'm glad you found that article. It's wild. It is wild. And I just think it raises the point there again of how many investments are marketed because it can sell, and people will buy 'em because it appeals to something emotionally for them, but it may not necessarily always be in their best interest, or people may not necessarily know exactly what they're getting into with some of these different investments. So hopefully, we bring some color to that. Yeah. So, you know, we talked a lot about private equity, private assets, and one of the areas that we hear a lot of these different companies are going into is artificial intelligence and creating some different solutions for that. So I think that can be a great topic for us going forward on a future episode. So let's make artificial intelligence a future episode. Thank you for joining us here today on "The Informed Investor." And be sure to hit that Subscribe button. Have a great day, everybody.