Private Markets Are Booming - But Who Really Is Partying?

As my firm, LCM Capital Managements, has been writing lately on Benzinga, there's no denying private credit and private investments are attracting a lot of attention as well as investor's money. A recent white paper from VanEck titled "The Democratization of Private Markets" stated private markets have exploded in size—growing from $4 trillion to $15 trillion over the past decade.

We believe however this is the next ticking time bomb and investors need to be very careful when entering these waters because there are plenty of sharks swimming. When this explodes, nobody knows, but it should be epic with a lot of finger-pointing in the aftermath per usual, think circa 2008 housing. You are already starting to see some cracks, although you have to look for them since my industry loves burying things, including their fees.

The financial media is buzzing with praise and Wall Street is launching fund after fund because of investors "demand". Investors are not actually asking for this, Wall St is however, once again, creating this demand and then telling/selling investors this is what you have always been looking for. However, growth alone in the demand for a financial product shouldn't impress you. Ask yourself, is this truly investor-driven demand, or is Wall Street simply manufacturing more product because it's lucrative? Remember, Wall Street creates what it can sell, not necessarily what's best for you.
Up until recently these products were only for institutional clients. The reason: they are complex, illiquid, non-transparent and risky. That doesn't exactly sound like what a retail investor is "demanding," not that it matters to my industry. In addition, these investments fall outside the traditional bank lending standards which should make you think, if the banks don't want to lend to them, why would I?

The products being created today for individual investors and now potentially even your 401k promise all the benefits of private credit investments plus the liquidity, simplicity and transparency. Hopefully, you are asking the same questions we are, how is that possible? Seriously. If the very features that define private markets, illiquidity, complexity, long-term lockups are now being "solved" by packaging them into an ETF or a mutual fund, you have to wonder, what am I really investing into?

Another supposed benefit of these new products is that they will offer attractive yields, some of which will float, meaning they will fluctuate with interest rates. Remember what was mentioned above, these borrowers you are lending to couldn't secure traditional financing, so the yields are higher for a reason—they reflect higher risk. Floating rates might protect you from inflation, but they can devastate already-strained borrowers, increasing default risk. You're not just buying income—you're underwriting someone else's stress test.

Lastly, let us not forget about one of my firm's main sticklers with our industry and their products, it's the "F-word", fees. You are going to pay your broker most likely an annual fee to procure this product. You're also going to pay an annual fee for the product itself. Then you're going to pay a fee to gain access to the firms that invest in these products. The VanEck white paper mentions investing via a BDC (Business Development Company). What's that you ask? A quick Google search explains a BDC is a type of investment firm that provides capital, primarily debt and equity, to small and middle-market companies in the U.S. They were created by Congress in 1980 to stimulate lending and investment in businesses that may have difficulty securing capital from traditional sources. BDC fees are complex (there's that word again) but important for investors to understand. They include management fees, incentive fees (based on performance), and other expenses.
Sounds to me like a lot of fees. So, for an investor to make money using higher fee products, the returns have to be higher, and for the returns to be higher that means more risk for you, the investor, who, don't forget, is demanding this product. Remember, the company selling you this has already made their money.

In summary, these products are being sold as bringing sophisticated tools to the masses but please don't confuse complexity for sophistication. Private markets may sound sexy, but the average investor has no visibility into how these assets are valued (I'm not quite sure the companies creating these do either), not to mention how they'll behave in a real downturn.

Private markets are booming, and Wall Street is more than happy to let you in to their exclusive party, but at a price. While these firms make compelling arguments about diversification and returns, it's critical to recognize the trade-offs: illiquidity, high fees, and valuation uncertainty. In last month's Benzinga article we wrote BlackRock believes these products could potentially increase (investors) returns by .5% annually and 15% more over 40 years.

Sounds to us that this is a party worth missing.

There is a better way.

Benzinga Disclaimer: This article is from an unpaid external contributor. It does not represent Benzinga’s reporting and has not been edited for content or accuracy.