What Investors Get Wrong About Semi-Liquid Private Equity

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One of the topics that I get asked most about today is private equity. Within the portfolios of German entrepreneurs and younger family offices, the asset class is still somewhat underrepresented - and while there are certainly reasons that would argue that today is not the best time to invest in private equity, there’s many other asset classes that seem even more challenged today.

And when it comes to investing in private equity, it’s semi-liquid funds that are all the rage: Rather than having to commit to closed-end funds over multiple years, all of which also invest over several years, investors can invest as fast as in one single tranche - allowing them to compound at the expected long-term return from Day 1. (If you want to learn more about Evergreen Funds, you can read my Rise of Permanent Capital series from earlier this year - click here for Part 1, Part 2 and Part 3.)

As with any asset class, there is warranted criticism. There’s the question whether private equity makes sense as a whole (see The Volatility Laundering Misconception). There’s questions around the fee load of the nascent evergreen fund industry, which in some ways seems similar to how mutual funds were priced before the dawn of the ETF (also a topic for a future newsletter).

But today, I want to tackle the #1 point of criticism for evergreen funds, heard from both supporters and opponents of private equity as an asset class: That semi-liquid funds are incredibly dangerous, because they do not offer liquidity to investors in times of crisis.

Out of the many, often warranted points of criticism for evergreen funds (two of which that I mention at the end of this article), I think that this is by far the least warranted one. And I want to explain my view to you from three different perspectives: Asset Allocation, Functionality, and Active Management. 

The Asset Allocation Perspective

Let us raise the question of who should actually invest in a semi-liquid private equity fund. 

The first key term is private equity - which I would define as actively managed (and often levered) investments in equity or equity-like instruments of mostly unlisted companies with the goal of achieving positive long-term returns, ideally in excess of a public equity benchmark.

And we can dissect that definition, piece by piece, to answer our question:

Actively managed (against) a public equity benchmark - outperformance from active management is rarely linear (except in the case of Structural Alpha), and hence, investors should expect for their performance to fluctuate relative to the underlying (public equity) index.

Levered equity- or equity-like instruments - which (like their public counterpart) can be subject to significant dispersion in performance, ranging from multiples of the invested capital, all the way to a full loss of invested capital. Leverage can be expected to enhance the performance in either direction.

Unlisted companies - firms that don’t have a public market on which their shares are traded. Hence, a private equity fund might not be able to sell their shares at a beneficial price at times, if they are even able to receive an offer for them at all.

Long-term investments - meaning that investors should have a multi-year investment horizon, and as mentioned above, should be ready to underperform the relevant public equity index in individual years in return for hopefully outperforming over the full lifetime of the investment.

If it’s not clear by now: Private equity is a risky, illiquid and long-term investment, and should be used in a portfolio in a way fitting that definition. At Cape May, we consider private equity as a long-term return driver within the Aspirational Investor Framework’s Market Bucket, typically as a ‘satellite’ next to a ‘core’ diversified, liquid asset portfolio.

Which brings us back to the question of a semi-liquid private equity fund. Many investors think that the semi-liquid characteristic of a private equity fund means that it is somehow less risky. And perhaps it is slightly less risky given its cash buffer - but that is only marginal: In the end, an investor still buys into a private equity fund, with all of its risks, illiquidity and intended long-term allocation. 

So to tackle the aforementioned criticism (not being able to sell in times of market turmoil) from the psychological angle (wanting to sell in times of market turmoil) that you always should have when tackling investment decision: You might be technically correct for complaining that you want to sell in a time of market turmoil, but cannot. But rationally, there is a good chance that you used a semi-liquid fund for a purpose (liquidity in times of crisis) that goes against its intended use (long-term returns across a full market cycle). It is the equivalent of every financial advisor telling you against selling low and buying high, but for private equity.

The Functionality Perspective

Frequent readers know that I am a big nerd for financial engineering and esoteric financial instruments. Hence, it is unsurprising that I am intrigued by the recent (although admittedly not-so-new) semi-liquid fund trend. As I have outlined in the aforementioned Rise of Permanent Capital series, my view on such products has changed considerably: I first viewed it as a way to raise funds from mass affluent individuals (at an often overpriced fee load), but have since learned to see it as a useful tool in the alternative investment tool box.

Tool box is the right analogy here, as you can see in the subtitle to this newsletter: Because tools work best when used as intended. If you use them in a way that is not intended, you shouldn’t be surprised if the outcome is less than ideal. And that is indeed the case for semi-liquid products. As we just touched upon, investors can’t expect ideal outcomes when using a product in a way in which it is not intended to be used.

But the tool box analogy goes further: Just because you can use a tool in a certain way doesn’t mean it should be used that way. 

Take a product that isn’t a semi-liquid private equity fund - for example, a humble S&P 500 ETF. Yes, you can technically sell it at the depth of a market crisis, during which your ETF sees a 50% drawdown. But should you do it? Certainly not: If you need liquidity in such a moment of crisis, you simply didn’t conduct proper liquidity planning - in other words, you should’ve not used a S&P 500 ETF for liquidity management purposes. If you don’t need liquidity but are investing for the long term, you shouldn’t care whether you are able to sell your ETF at a 50% loss or not - you just shouldn’t do it.

The same logic applies to the semi-liquid fund. Yes, you should technically be able to sell if the documents say so as long as there is no active gating provision*, even in the most dire of market events. But if you want to sell in such a phase for a reason outside of a catastrophic event in your scenario, and end up not being able to because of the fund’s limits - the fault isn’t theirs, it's you and your liquidity planning.

(* So-called gating provisions can be triggered by the fund’s manager to limit how much of a fund’s overall net asset value can be redeemed per quarter, i.e. 3 to 5%, and/or it might limit redemptions from the fund entirely for a certain time period.)

The Active Management Perspective

We’ve now looked at the matter from two angles: First, the Asset Allocation Perspective, meaning that you should still see semi-liquid private equity as a long-term private equity investment. Second, the Functionality Perspective, outlining that you should use an instrument such as a semi-liquid fund in the way that it is intended to be used, and not a way that it can be used but that is against its core purpose. Lastly, the Active Management Perspective.

Let’s leave my prior two points aside. Let’s assume that someone had used a semi-liquid private equity fund how it is meant to be used, i.e. long-term and return-oriented, and not for short-term cash management. Let’s also assume that their reason to sell it during a time of market turmoil is actually valid - maybe they’re up 10.000% and it’s the only thing to sell at a gain.

So said investor did allocate correctly to private equity, they are right to sell that semi-liquid fund. But oh, snap: they are hit by the gating provisions we talked about before. How unfair to them!

Actually - no. It’s not unfair to them at all, and maybe even in their best interest.

First, gating provisions shouldn’t come as a shock to an investor. They are somewhere in the many, many pages of that semi-liquid fund’s LPA or risk disclosures. I don’t want to deny that there are financial advisors out there that sold such products without outlining gating provisions - unfortunately there are many bad apples out there, and the new alternative investment trend will likely bring many more such stories. But it’s not the fault of the private equity firm - they have such provisions in there for a reason.

Which brings us to the second argument: That gating provisions are actually in favor of an investor. Remember late 2022, when the most famous semi-liquid alternative investment fund, Blackstone’s BREIT, limited withdrawals as real estate struggled in a rising rates environment. Many investors complained of not being able to redeem their shares - but from my point of view, and likely Blackstone’s point of view, that choice was for the better: Yes, they technically could've conducted a fire sale of assets at the then-depressed market price to fulfill all redemptions. But would’ve investors been happy with that? Likely not - even though they wanted to sell.

And that brings us to a final point that investors shouldn’t forget: That private equity is an actively managed product. Assuming that gating provisions are present in the legal documentation, it is entirely in the manager’s best interest to trigger such provision when they deem it to be most useful of their investor’s outcome, even if that is almost always during turbulent times in the market. Investors should be mindful that they (hopefully!) chose to give their money to the GP of a semi-liquid fund because they thought that they would be better active managers than the investor themself. ‘Better’ is a question of technical expertise, i.e. in the case of BREIT, better knowledge of real estate investing - but it is often also a question of psychology, meaning that they can be relied upon to hold good companies through challenging times.

The Counterpoint: Where To Be Careful

To summarize my case for semi-liquid products, I would like to return to the tool box analogy: Semi-liquid funds aren’t good or bad per se, they always need to be viewed in the context of a certain situation and a certain market environment - and depending on where those two variables stand, a semi-liquid fund might or might not be a good investment. Accordingly, many of the issues with semi-liquid funds come not from issues with the product, but issues of incorrect use.

But admittedly, semi-liquid funds, as most products out there, aren’t perfect. Even though some funds have been in the market for a while (Partners Group’ first semi-liquid fund launched in 2001), the semi-liquid trend has been most present in the last few years - and as with any new products, there’s issues to iron out. There are two major concerns that I see today:

First, the asset-liability mismatch. While many GPs have measures for emergency liquidity management in place, semi-liquid funds by nature have a duration mismatch of short- to medium-term liabilities (redemptions) and medium- to long-term, illiquid assets (stakes in unlisted companies). During substantial market turmoil, there will always be a risk that even after gating provisions, a fund can not match all of their redemptions, and at worst, might have to be (orderly) wound down. Hence, even if products are technically semi-liquid, we would always advise investors to expect the worst - i.e. not plan on them for liquidity needs, but as a private equity-like long-term investment.

And second, and more importantly, the question of mark-to-market pricing. I’ve tried tackling the Volatility Laundering point of criticism before: Complaints stating that private equity firms are more flexible in setting the prices of their investments, especially by not marketing them down in market corrections. For a closed-end fund, the NAV (except perhaps for institutions using those NAVs for loans or similar) doesn’t really matter, as in the end, only the final exit price of an asset decides an investor’s return and the GP’s carry - to me, it’s not too different from a small-cap equity fund telling you that while prices are down, the intrinsic value of the shares they hold (at a loss) is actually much higher.

But for semi-liquid funds, things are admittedly a reason to be skeptical about. In a semi-liquid vehicle, carry is paid not based on liquidity events, but based on the NAV of the fund - similar to the carry mechanism of a hedge fund or mutual fund. But unlike that hedge fund or mutual fund, which sees their underlying NAV fluctuate based on market prices, GPs are able to influence the price of the underlying assets - and thus, their carry. The results are interesting, to say the least, such as the aforementioned BREIT triggering its gating provisions despite an increase in NAV in the most challenging environment for real estate in over a decade. While so far, that criticism has been limited, it is a concern and admittedly a conflict of interest - after all, if the GP can set the NAV that drives their carry, we really get to the point where we have to question the private equity fee model.

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