Let’s talk about markets and price signals. Don’t worry, this is simple stuff.

If something doesn’t sell, and you want to sell it quick, what do you need to do?

That’s right - lower the price!

Told you this would be easy.

Now this hypothetical thing that you want to sell… if you are asking too much money for it, nobody will buy it, right? That seems pretty simple.

Let’s say there’s this other hypothetical thing that you might own with thousands of other people. Let’s say that this hypothetical thing is… oh, I don’t know… a portfolio of mortgage loans.

Now let’s assume that you are telling your fellow investors that one unit representing their interest in this portfolio of loans is worth $1000. But a large number of these people believe that the value of these loans is declining quite rapidly. What might these people do?

That’s right, they will cash out their investment unit at the $1,000 you are telling them it’s worth.

If enough people do this, you might have a problem. Because these loans do not trade on a public market, it will take time to find someone to sell them to. If you have to sell quickly, you might have to reduce the price and take a loss on your portfolio. It’s even worse if a bunch of your borrowers are behind on their payments. And so what you can do is tell your investors “sorry, but you can’t get your money just yet, please be patient.”

And this is all fine, except you are still claiming that their investment is worth $1,000 per unit.

Is it really?

You won’t give your investors $1,000 for their units.

I wouldn’t be willing to pay that much for one of these units. Would you?

Here’s the crazy part - all of these investors are going to get investment statements showing the value of these units at around $1,000. This is a lie. Everyone involved knows it’s a lie. And yet, this is just how things are done in the private investment sphere.

The managers of these investments market them as “low volatility” and “uncorrelated with public markets,” but this is only because, as illustrated above, they are slow to adjust the “price” of the units. They make up numbers to suit their story.

Because private funds don’t trade on a public market, investors don’t see the price zigzagging around every day and assume the investments are doing just fine, even as dangerous cracks are forming beneath the surface. Cliff Asness of AQR Capital calls this “volatility laundering.” I devoted a chapter in Low Risk Rules to the idea, with the title, “The Volatility You Can’t See is Still There.” 

If you’ve been paying attention, you might be noticing that recently, the cracks are starting to make their way to the surface.  

In Canada, Romspen, one of the largest private mortgage lenders, a fund that promised investors high single-digit returns, has taken steps to limit redemptions from its flagship fund. That means if you have money in the fund you would like to withdraw, you’re going to have to get in line behind other investors who have already asked for their own money back. The manager doesn’t have the money to redeem your units. 

You would think that this disappointing news would be reflected in the value of your investment in this fund. 

You would be wrong. 

If you’re wondering how the fund is performing year to date, a visit to their website shows that for the first three quarters of this year, it’s up 8.3%. Nothing to see here!

Are you willing to believe that the value of your investment is up 8.3% this year, even though the fund doesn’t have the cash to redeem your units?

If so, you’re just the type of investor a private fund is looking for.

Despite this limit on redemptions, the fund’s marketing page still has the audacity to show you a graph demonstrating the “stability” of their returns since 1997, versus stocks and bonds.

Speaking of audacity, if you’d like to donate to the cause of helping existing investors get their money back, the manager conveniently links to subscription forms for new investors. You’re free to buy into the fund at the same price at which they refuse to redeem existing units. So there’s that. 

Unfortunately, this is only the tip of the iceberg. The big news this past week is that the $69 billion Blackstone Real Estate Income Trust (BREIT) has taken the same steps of limiting investor withdrawals. This was followed by the $14.6 billion Starwood Real Estate Income Trust (SREIT), which has also limited redemptions. See a pattern developing here?

Let’s continue to spot patterns. Wonder how your investment in BREIT is doing? Well according to the fund manager it’s having a great 2022, up 9.3% year to date. SREIT is up 10.2%. Wow, investors must be thrilled!

The Vanguard Real Estate Index fund, a close approximation of a public vehicle owning the same types of assets, is down 24% this year.

Which valuation do you believe - the public one, or the private one? 

If you were a new investor, would you be willing to buy at the private listed price, or would you rather believe the signals in public markets? 

If you’re an existing investor, would you prefer to know what your investment is actually worth, or are you happy with the private valuation?

I’m not here to pick on Romspen, Blackstone, or Starwood. What I’d like to make sure investors understand is how private market investments hide volatility from your sight. Some investors actually prefer this, because it keeps them invested through rough periods. But realize that if this is your viewpoint, you are essentially paying your private fund manager to lie to you.

The Economist covers this topic in this week’s issue, asking “has private equity avoided the asset-price crash?”

Spoiler alert: no.

I’ll skip to the article’s last line: “soon private-fund managers will have nowhere to hide.” In between the article discusses the many ways that private equity managers can “smooth” returns over time, further adding to the obfuscation of what’s really going on in your portfolio.

And yet, the hawkers of “prestige investments” will tell you that the fund values have not been marked down because the issues currently faced by these managers are “temporary,” “transitory,” and simply put in place to avoid having to sell assets into a declining market. Fair enough, but investors only need to realize that in the interim they are not getting an accurate picture of what’s happening to their investments, lulling them into a false sense of security.

If markets stabilize and recover, investors will be none the wiser.

But if they don’t, they could just be setting themselves up for a violent reckoning down the road.

But that’s a topic for another essay… in fact, it’s one I’ve already written. If you have a copy of Low Risk Rules, check out the story about Southland Royalty in Chapter 11 (under the heading Gradually, Then Suddenly). It serves as a cautionary tale for what might be awaiting today’s private equity investors.