← The Long View
The Long View
Leyla Kunimoto: Why Investors in Private Markets Need a Louder Voice
00:52:56
The founder and editor of Accredited Investor Insights on performance measurement, disclosure issues, and liquidity considerations for private equity and private credit.
Loading summary
Transcript53 lines
- [00:00]
A
In private equity secondaries, relationships aren't just an edge, they're everything. Trust and reputation open doors long after deals close. For 10 years, the Pomona Investment Fund has brought institutional private equity exposure to individual investors, delivering opportunities others can't. Think private equity is just for large institutions, think again. All investments carry risk, including possible loss of principal. For details on the Pomona Investment Fund and its risks, Visit Pomona Investment Fund.com investors.
- [00:30]
B
Please stay tuned for important disclosure information at the conclusion of this episode. Hi and welcome to the Longview. I'm Amy Arnott, portfolio strategist for Morningstar.
- [00:42]
A
And I'm Jeff Patak, managing director for Morningstar Research Services.
- [00:46]
B
Our guest on the podcast today is Leila Kunimoto. Leila is the founder and editor of Accredited Investor Insights, a newsletter that helps investors navigate private markets. She writes about private equity, private credit and real estate, focusing on the practical realities of evaluating alternative investments from the limited partner perspective. Laila began investing in public markets in 2001 and expanded into private markets in 2020, with current holdings spanning public equities, real estate and alternatives. She started her career in finance and management consulting after graduating from the University of Washington. She also worked in advisory services at a big four accounting firm. Layla, welcome to the Longview.
- [01:34]
C
Thank you for having me.
- [01:36]
B
Well, it's great to have you here. We wanted to start out by talking a bit about your background. You've been investing in single family housing since back in 2006 and manage a small real estate portfolio in the Seattle area. How did you first get interested in real estate investing?
- [01:56]
C
Yeah, so the timing of course was good on our end. I first got introduced to this because after reading the Rich Dad, Poor dad, which probably defined my generation of investors at the time, we did fairly well with single family homes. It was my husband and I who started kind of assimilating a portfolio and time wise it worked in our favor. And I've always liked real estate because it's a little bit less of an efficient market. There are some pockets of imbalance and back in, you know, especially after the great financial crisis, there was an opportunity to take advantage of those imbalances. There was very clear value and I sort of jumped on it.
- [02:44]
A
How did you first get involved in other types of private market investing?
- [02:48]
C
So my gateway was real estate and real estate private placement. At some point, the deals were difficult to come by. Numbers didn't pencil as well. And in the middle of the pandemic in 2020, I looking at, I was introduced to syndicated real estate investment and what that is, it's kind of a vehicle that allows somebody to go out and buy a large, you know, let's say multifamily property, raise capital from individual investors and that is the equity that goes into those deals. So that was multifamily. Syndicated real estate was my gateway to private markets. From there it kind of expanded fairly quickly into other asset classes. In real estate I currently, you know, I'm exposed to everything from mobile home parks to retail strip malls. You know, it's kind of the world's your oyster. Once you enter that space, you can get exposure to a number of different asset classes. And then from there I started networking with other individual high net worth investors and joined a number of investor groups, started attending conferences and fairly quickly kind of got into the broader world of alts, alternative investments, private credit, private equity, you know, venture capital, that kind of thing.
- [04:15]
B
That's interesting. And you co founded Accredited Investor Insights, which is a substack newsletter that focuses on private markets from the perspective of a limited partner. And it seems like in this area there are relatively few independent voices that are willing to say something critical about a general partner who's managing a private equity, a private credit portfolio. Why? Why is that? Is there something about the market structure that makes it more difficult for those independent voices to be heard?
- [04:57]
C
You know, I think it boils down to, you have to follow the money in this space. And in private markets, most voices sit on the sales side, right? You know, most of the information that's out there is put out by either general partners, the people who are doing the deals and running the funds, or the wealth channel. And those are the people who provide access for investors to invest in those offerings. So I was allocating my own capital. And in the early days it was extraordinarily frustrating because there were no voices that spoke from my point of view. I'm a retail investor. I have access to a number of those offerings. I qualify, I meet the investment qualifications to invest in them. But there was not a voice that was kind of clear and independent and unbiased, if I may say that. So the newsletter and I started writing about this several years into this process because I wanted to. I clearly saw that there was a need for that voice for investors. To this day, there's not many people from my position, people who are allocating their own capital. There's not many of us who are looking at those markets and kind of trying to grasp what's going on. So the newsletter was started as a side project. I wanted to level out the playing field a little bit. The information that's coming out right now, there's a fair amount of it. There is not a lot of voices who are saying, well, wait a second, let's. Let's kind of peel the onion back a little bit and let's see what's inside, what's under the hood.
- [06:39]
A
That's very interesting. I wanted to shift and talk a little bit about private credit, something that's very topical at the moment. Given the recent collapse of First Brands Tricolor Food Group, there's been plenty of debate about whether these bankruptcies are canaries in the coal mine, so to speak. Do you think these cases indicate broader issues with underwriting quality or covenant quality, downside protection and private credit?
- [07:04]
C
That is a good question. And it's, you know, obviously we were all reading the headlines and we're told that perhaps, you know, maybe it's not as much of an issue. My personal opinion is that they are a cannery. They're a tell. Right. There's something. So over the last decade, we've had extraordinarily low default rates and private credit. The space has grown. It's grown gangbusters. There is a lot of money that's flown into the space. A lot of money was raised from retail individual investors. And there is no end in sight to that money being raised. It seems at the same time there was this era of very low interest rates when it was very inexpensive to get fluffered up and spend. Those companies, the companies that get that debt, some of them are owned by private equity firms. And for a lot of those companies, that debt was cheap and readily available. So from the first principles perspective, when you look at it, when you have a situation when a lot of capital flew in into a space and it had to be deployed, I do question the robustness of underwriting.
- [08:22]
B
Yeah. We've also heard quotes from people like Jamie Dimon saying that he thinks private credit could pose systemic risks similar to before the global financial crisis. Do you agree with that take?
- [08:38]
C
So Jamie Dimon is a highly intelligent person who knows far more than I do, and I would kind of start with that. My take on the space is I don't think the entire space is a house of cards by any means. I also don't think that the cases, you know, the First Brands and Renovo recently, I don't think these are isolated cockroaches. There are probably more cases of stretched borrowers and loans that were issued with a little bit less oversight perhaps. But as far as systemic risk, I think there is a big difference between what was going on in 2008 and today. And I think it's important to understand for all of us that what we're seeing today is a lot of private capital that is not tied to the banking system. So private credit is referred to as the shadow banking. It obviously came about, it grew out of the regulation that followed the great financial crisis and it's far less regulated. But it's also, it's private money. It's well dispersed. We're told that a lot of sponsors hold those loans and it's in their interests for those loans to be successful and to pay off. A lot of borrowers are backed by private equity. So there are a lot of good and solid things, but there are some, you know, some questionable practices. Perhaps we're reading again in the headlines that we see. Underwriting is probably when you have a lot of money and when you need to place that money very quickly, there is an incentive for the lender to maybe overlook or be a little bit looser on covenants or maybe loosen up your underwriting criteria a little bit. So I think from my point of view as an investor, it's really difficult to say whether it's going on or not. But seeing all the other kind of surrounding factors around it, the money being raised, just how aggressively it's been marketed to investors, how aggressively private credit is being marketed as the next best thing to everybody from institutional investors to retail investors, I think there's good reason to take pause and kind of think about what might be some issues investors need to think about.
- [11:23]
A
I think we want to dig into the dynamics there. Too much money chasing, too few deals, a watering down of protections for lenders. Before I did that, just a rudimentary question for me, if I wanted to try to ascertain the markers of stress in the private credit market, what are the sorts of things that I would look for? I think that more familiar to us are measures in public markets like, you know, bond spreads, credit spreads and high yield or a vix, the old TED spread, things like that. What are their counterparts in private credit markets?
- [11:59]
C
So if you wanted to ascertain, spreads are a good kind of benchmark, a good thing to look at, and spreads have been compressing. So the one important thing about private debt is the opacity of the space. Right? And this is. It's a feature, it's a well known feature. I dislike it personally as an investor who looks at the fundamentals, I don't like opacity. I want transparency and I want to know as much information as I can possibly get my hands on. But in private markets, if there was distress. So let's say you take your business development company bdc, whether it's traded or non traded, a company that's incorporated under 1940 act, for example, that has to file, let's say they have to file the SEC filings quarterly. What you would be looking at and the only kind of thing you're tracking there is obviously non accrual loans and the incidence of that. But the second thing you are tracking is payment in kind. And payment in kind. I think from my standpoint it is the only reliable signal for when I evaluate private credit funds. Because today with a bank loan there are very defined rules around what constitutes a default. So if a borrower stopped paying to a bank, they go into default after a certain number of days, right? It's a 30 day default, 60 day default. And that is clearly reported with private credit. Because these loans are bespoke, virtually every borrower can have a very customized solution that meets their needs. Some borrowers borrow money with pic and pic is payment in kind. So a borrower can come to a private credit lender and say, hey, I want to borrow a $15 million loan and I'll pay you 15% interest, but let's tack that interest to the balance of the loan and that's doable. That's option one. Option two is I'm a borrower and they come to a private credit lender and they say, hey, I want to borrow that $10 million loan and I'll pay you cash, I'll pay the interest in cash. But I want to have the option if I needed to, if I ran into some cash flow problems on the business side, I want to have the option to turn on that pick to at some point say, hey, I'm going to switch to payment in kind and you'll just tack on that interest that I owe you to the loan balance and they'll pay it off when I pay it off. So it becomes very difficult. Like when we look at that the lender obviously knows the health of the borrower or we think they know. And for the lender, from the lender's perspective, if the lender had agreed to issuing them a pick loan and if the borrower is, you know, turning on that pick toggle and starting to pay interest in kind of, from the lender's perspective, that borrower is in compliance and it's a current loan. What's going on on the borrower side? We don't know. And certainly investors on the investor end have no visibility into it. And there's a number of good reasons to have pid. And some, you know, some tech companies, they simply don't generate. They're growing so fast and they're, you know, they're burning through cash and that's not necessarily a bad thing. And for them, loans that don't necessitate cash interest service, they are kind of a vehicle to grow rapidly and that's a good thing. But that said, from the investor perspective, PIK is about the only measurable thing in those financial statements. So I can take a look and I can kind of look quarter to quarter and say, okay, with this lender, with this BDC pick went from 6% to 7% to now 11%. That's probably a signal that the borrower base is becoming distressed. Is it a clear signal? No, but it's the best I got. So from my perspective, that's the one thing that is worth tracking.
- [16:25]
B
So is there a way to track that kind of across the private credit landscape if you're trying to measure how PIC financing has increased or is it more anecdotal from looking at what's going on with individual deals.
- [16:44]
C
It is most certainly trackable. It is reported. PIC loans are reported on every lender's books, in every lender's quarterly reports. Some make it easier to find and others don't aggregate it. But anybody with a calculator can go into a Q3 report. And pic loans are usually called out in the income statement. Fairly easy to find them. And you know, you will see a huge variance between lenders in the number of PIC loans. So that PIC interest shows up as income, but it's not cash in the bank. Okay, so if a private credit fund that issues loans and pays distributions to their investors, as an investor, what I care about is can they cover that distribution out of the cash received, you know, from their loans. And PIC starts factoring in when it becomes high, low. PIC doesn't really, you know, doesn't move the needle a whole lot. Low amount of pic, but higher amounts. We have some, you know, well publicized cases of public BDCs where pic was so high they couldn't service the distributions and then have to cut the distributions or dividends to their investors. So it's certainly trackable. It can be done with a calculator. But you do have to open those financial reports and you do have to look for it.
- [18:11]
A
So certainly payment in kind pick sounds like one of the things that someone should be aware of as they're assessing a particular private credit investment, so to speak. Maybe you can also talk about multiple levels of leverage that's sometimes involved in private lending. What should investors be aware of? There's.
- [18:31]
C
So investors should be aware of two things. The number one is maturity schedule of a fund's holdings of a fund's borrowings. And by that I mean it can get pretty complex. In some of the larger funds, we can see billions of dollars of borrowings. It's a good idea to keep an eye on how those maturities are staggered. So a fund may have very well staggered maturities, or it may have a lot of maturities that are coming up in, let's say, 2026 and 2027. This is something investors should be aware of. And number two is the structure of the debt itself. And we can see a number of variations in that space. Some funds will have very complex structures, especially larger funds. They will have a lot of different types of debt on their books. You can see that on the balance sheet in the footnotes. You will be able to see how these funds structured that debt. There are a couple of things here we'll want to keep an eye on is the debt. Are the funds borrowings fixed or floating? And let's say they're fixed. And let's say they were originated in 2021 at a very low interest rate. That's accretive to investors in the fund because the assets are floating. And those assets, those loans that the fund issued, have floated up since 2022. So the fund is earning more money than they did, but the debt is fixed and it's low. But the one thing to be aware of here, of course, is when that debt matures and the impact of refinancing that debt, that would have on the fund's cash flow. And from there it can get really complex. And some funds keep it simple and issue notes for bonds. Other funds clos collateralized loan obligations, they securitize some of their assets, some of the loans, and sell off the upper trenches and hold the equity position in that. So both of those things are equally important. It's important to be aware of them. And it's important to see the impact of interest payments and how they kind of look a couple of quarters ahead and see how that may change in the quarters and years.
- [20:51]
B
Also wanted to ask kind of from a broader perspective, how should a retail investor think about private credit? And if an investor or financial advisor wants exposure to private credit as part of a portfolio, what type of vehicle is Most appropriate.
- [21:12]
C
So with private credit, it's a little bit easier because the number of vehicles available to investors is not, you know, they're not all that different. So the options include BDCs, and these are business development companies you can access. Anybody can access credit credit via public markets. This is equity in those companies. And there are plenty of publicly traded BDCs that have a lot of history to them and have been around for a number of years. An investor could allocate to a non traded bdc, which is available through an ria, through the wealth channel. Right. Or investors can allocate to a traditional closed end drawdown fund which has almost no liquidity options until that fund kind of realizes those investments. Private credit. I think the vast majority of new private credit funds that I'm seeing are in the first two categories. So there's not as many public ones, but there is a lot of new funds that have come out. There are non traded BDCs. That's probably, I would wager a bet that's probably the number one most popular option. Those funds certainly have raised enormous amounts of capital over the past couple of years.
- [22:32]
A
Why don't we shift to private equity and maybe we'll start sort of at a basic level, which is how you measure how one has done in private equity. And one of those measures, public market equivalent PME for short. You've been critical of it. Pme, it's a metric that attempts to measure if a private equity fund outperformed what an investor would have earned by investing the same amounts of money in a public index at the same time. What are the issues with pme? That metric?
- [23:02]
C
Yeah. Let me provide a little background for listeners at home. So PME measures the performance of a drawdown fund and kind of finds a benchmark to compare it against in the public markets. The biggest problem there is the nature of a drawdown fund and the nature of how that fund deploys capital. I'll give you an example. Let's say you are a fund manager and you come to me, I'm the investor, and you say, hey, I'm raising this wonderful private equity fund. We have a fantastic track record going back a decade and we're raising the next fund. Would you commit to that fund? Would you be interested in investing? And they say, well, yes, you're a wonderful fund manager. Let me allocate some money to this. Let's say I, an investor, I commit whatever $100,000, right? That $100,000. The day I commit to your fund is not the day I invest $100,000 into your fund, you are going to have, as a fund manager, you're going to have typically a two year period of when you're going to go out and find investments and deploy the capital. During that time, you may be using some subscription lines or credit facilities to fund those purchases. And then you'll call my money and you can tell me that, hey, Leila, I'm going to call 50% of your committed capital at the end of year one and the other 50% at the end of year two. So I have, at the beginning of year one, when I committed capital to you, I did write you a check. I have to sit on that money for the period of two years until all of my capital is called and I have to do something with it. But I can't go into an illiquid investment with that hundred thousand dollars. Right? I have to fight something that is fairly liquid that I can withdraw so that I can fund my commitment when you call my first $50,000. So the problem there is with PME. The PME starts counting when that $50,000 was deployed. Okay? For me, for the investor, that's not when I committed the capital. And I'm not going to earn 15% between the day I committed capital and deployed it. So there is a bit of a drag versus contributing from the investor perspective. I can do that or I can commit $100,000 to an ETF, you know, a public market fund. I can commit 100,000 and I can fund that commitment the same day. So there is that drag. There is the problem of on the end, we're running into the same problem. You, the fund manager, let's say you bought 10 investments and a certain number of years passes, you called my capital, you bought the investments, you did all you were planning to do and you generated great returns. When those investments sell off, you're going to be returning my money in chunks. It's not going to all come to me in one fell swoop. You are going to be making distributions as investments are realized. That's another problem. In order for me to match the performance in a public market, I have to do something with that money. I have to continue earning a return on that. And, and I can't necessarily immediately deploy out of 100,000. If you return 12 to me, I can't immediately deploy it into the next fund that has the same strategy. So it's an imperfect metric. There is nothing better. We have to compare somehow with that metric. There is a lot, there's a lot of assumptions and we have to figure out a way to compare. But the metric doesn't allow us to compare apples to apples.
- [27:02]
A
In private equity secondaries, relationships aren't just an edge, they're everything. Trust and reputation open doors long after deals close. For 10 years, the Pomona Investment Fund has brought institutional private equity exposure to individual investors, delivering opportunities others can't. Think private equity is just for large institutions, think again. All investments carry risk, including possible loss of principal. For details on the Pomona Investment Fund and its risks, visit pomonainvestment fund.com investors.
- [27:33]
B
So another commonly used metric in private equity is IRR, internal rate of return. And we've also heard many people criticize that metric. Is that better or worse as a way of measuring performance than pme, in your opinion?
- [27:54]
C
Irr. I love the Howard Marks quote. You can't eat irr, right? IRR is a time sensitive metric. It's a metric that is extraordinarily sensitive to when the capital gets returned to me. And that feature of that metric makes it very easy to manipulate. So an IRR can be artificially boosted by simply returning my capital back to me. I'm seeing, and you know, I read about this, but it's a terrible practice in private placement real estate deals. I'm seeing a number of deals where the GP will over subscribe the deal and then return some of that capital to investors because they want distributions. Well, what that does on the IRR side is it inflates it without necessarily generating a higher equity multiple. For me, the investor, I think the answer, I don't think there's one perfect metric. I think for investors, the way to evaluate private market opportunities is to look at the cohort of several metrics. And DPI is one of them. IRR is one of them. IRR tells you how fast the money came back. DPI or distributions paid on capital will tell you the chunks of what amount of capital was returned. And then the equity multiple is some sort of a metric that captures overall return on your money. That's the metric that needs to be taken in to compare. So you have to look at those deals and funds holistically. And that's the only way to do it, is to compare them across multiple metrics.
- [29:33]
A
So when you do that for different PE vintages, do any performance trends jump out at you? For instance, has it fallen off in more recent vintages?
- [29:43]
C
Let's say so in more recent vintages. And this is well documented. DPI distributions to paid on capital are the lowest they have been in over a decade, which tells us that. So private equity funds will return capital when investments are realized. And we are hearing that there's a massive backlog, exit, liquidity backlog, investments are not being realized. There's volume of transactions is down, dollar volume is down. So all of that is translating into lower DPI because sponsors or general partners can only distribute capital really when investments are realized and the companies, the portfolio companies are sold. The trend, major trend that's been going on and that's the trend that, that gave birth to the whole secondary space. Right. And we can discuss that. The trend is there's fewer exits and there's less money coming to limited partners from those funds than we have seen historically or than what we had seen in the 10 years prior to, let's say 2023.
- [30:55]
B
So what is that liquidity bottleneck mean in terms of kind of follow on effects? Is that part of the reason that there's been such a big push to expand private capital into retail markets? And if private equity firms and their investors are having more challenges exiting their positions, do retail buyers end up with kind of lower quality investments that the larger firms don't want?
- [31:27]
C
So I, I will say this. There's a dichotomy right now. So large institutional investors are selling their positions because they need liquidity or they're rebalancing. You know, I've seen the headlines, right? The large university endowments are selling off their LP stakes. They're selling off their positions in those funds, by the way. It's not a very large percentage of what they hold. Just as a side note. So it's not a fire sale by any means, but we see the headlines, right? So at the same time, from my seat, I see this push into the retail market. Is it solving that problem? Yes. Is it caused by that? I don't know. And I couldn't tell you this, but there's certainly, I mean, is there causational effect? I don't know. But we're certainly seeing those two things happening in cohort at once. I think the bigger thing that's happening, and that's a very direct. Right, very direct relationship is we have this liquidity bottleneck. The portfolio companies are not being exited at the same velocity as they had been in years prior. So what's happening now is we see a proliferation of secondaries funds. And secondaries funds come in and say, and they'll us buy stakes in those primary funds from large institutional investors, endowments, you know, pension funds. So those secondary funds buy stakes and they solve a problem for the Endowments, Right. If you're an endowment and you need to raise capital or you need to rebalance your portfolio, if the gp, if the general partner in the fund that you're invested in is not exiting the portfolio companies, your option to generate liquidity for yourself is to sell that stake, the ownership stake in that GP fund, and that's how they're generating liquidity. The unfortunate thing here is for retail investors, if I'm an investor in one of those closed drawdown funds, if I'm one of those investors, the problem becomes I don't have an exit button with my small stake. Unless your stake is sizable and sizable, as you know, a million plus, there is really not a good way to exit that. So individual investors should be aware of that dynamic. The secondary market is available and it's robust and there are plenty of platforms that facilitate that transfer of interest. But that is for large investors. Retail investors typically will not have that option.
- [34:12]
A
I think we want to talk some more about transparency and disclosure, particularly in the context of secondaries. Before I did that, I did want to. Since you mention sort of the difficulty associated with maybe a smaller investor unloading their position in a private equity position, let's say, what is your take on some of the major brokerage firms like Schwab Morgan Stanley buying private market trading platforms? Do you think it alleviates that issue any?
- [34:39]
C
As it stands right now, it doesn't, but I am extraordinarily optimistic about the prospects and I think, you know, five to 10 years from now that problem is going to get solved. So the train of access to private markets for retail investors is common. It's well on its way and I think it would be unwise to think that, you know, anybody is going to stop it. It's common and by and large, I think it's a good thing investors, it's a good thing to provide more access, access to investors. My menu of option expands. Right. As an investor, it's always a better thing for me to have more options to choose from. The problem there is and what we're seeing with those platforms, buying the private markets platforms, we're seeing that trend that just kind of goes with the overall trend of democratized access. Now the trouble with private markets is lack of transparency and lack of liquidity. There are brilliant minds who are working on both of those things, of that I am absolutely sure. And I truly believe that in five years time there is going to be a way for me to exit some of the smaller positions that I hold. How it's going to be done? I don't know, but I'm very confident it will be solved.
- [36:08]
B
So I wanted to follow up on the secondary funds that you mentioned can be a positive thing in that they are able to step in and provide liquidity for larger investors. But there's also this phenomenon where they can step in and buy shares at a discount to NAV and then immediately mark them back off up. So you have sizable paper gains that in some cases can attract more inflows so that they have more capital to deploy to sort of rinse and repeat. Do you think that the accounting standards should change to prevent this kind of pattern where you could argue that the returns they're getting are kind of artificially generated?
- [36:56]
C
With all my heart, I do. I do think that that practice that needs to change, the accounting standards need to change and more disclosure needs to be done about it. And this we're touching now on a very big topic, overarching topic, is how are valuations in private markets arrived at and with secondary funds, funds, what we're seeing, and I'll give a little bit of a background for somebody who maybe is not as familiar, but let's say a secondary fund comes to an endowment and says, hey, the endowment is selling their stake in fund A. Nav, or net asset value of fund A is, let's say $25 a share. But the endowment needs cash and they're willing to sell it for $15 a share. The secondary is funded, buys a stake at $15 per share, however many shares they buy the next day. The practical expedient rule allows this fund to immediately mark that $15 to $25 or whatever that NAV is that net asset value is. This can happen within 24 hours of recording the sale. Some funds are structured in a way where the general partner gets paid on total returns, realized and unrealized gains. So that $10 Delta per share is unrealized gains. The fund did not get that cash in. They simply bought something at a discount and marked it up immediately to whatever the ticker price is. Right. It's like you go to a car dealership buying a car for $45,000 at below invoice price. But you come home and on your own balance sheet you say, okay, I bought a car for $45,000, but the sticker on that car was 52. So I'm going to immediately put it on my books as an asset that's worth $52,000. This is exactly what happens here. And we can argue we can record another two hour podcast about Valuations, but that is the secondary funds. Funds show these gains. And there is an arc with secondaries funds when these gains are robust in the beginning, if a fund is able to buy a lot of assets at a discount and immediately recognize those unrealized gains, on paper, those returns look beautiful. When on paper you're generating double digit returns every 12 months, investors look at that growth and they say, my goodness, I'm missing out. I'm going to allocate some money to this fund. So these funds, in the early days, virtually every single one of those funds, secondaries funds, has very robust fundraising. Some of them grow to billions of dollars without borrowing a dollar in debt because fundraising is so fast, they don't even have to borrow money to buy those assets. But then there comes a point where the fund becomes large and any marginal dollar on top of a large number weighs a little bit less right on the overall structure. So that's playing out right now. There are a lot of secondary funds. A lot of them are targeting retail investors. Retail investors love them because a lot of those funds are structured as interval funds or tender offer funds. So they provide liquidity at certain points in time or they allow for some liquidity. It's semi liquid, right. They're not super liquid funds, but there's an option to redeem your shares and they are. They're a very popular product. There's a number of them.
- [40:47]
A
So maybe if I could just to jump back to your example, the nav of the private equity sort of investment, 25, the secondary buys it at 15. It sounds like what you would suggest is that the accounting, basically the secondary should be marking that position somewhere between 15 and 25, not immediately marking it back up to 25 for an instant $10 unrealized gain. There would be a little bit more accuracy. That takes into account the fact that they bought this thing at 15, suggesting that the $25 mark may not be the right mark. Is that right?
- [41:25]
C
So with the public markets, if I buy a share of a company at a discount, fair market value is what I paid for it, right? And this is economics 101. What's the value? Is the value what the sponsor tells me what the value is or is the value of what I'm willing to transact with another willing party. And this boils down to that. So I'll give you a roundabout answer. But let's say a primary fund, a fund that holds private equity firms, right? It's primary fund. They invested directly into those companies and has 10 limited partners who each contributed $10 million. So all of those limited partners can go out into the secondary market and sell the stakes in this fund at a discount. Let's say all 10 collude and this wouldn't happen. But I'm giving you an example. Let's say they all collude and they say, hey, you know what? We want to exit this. This. Let's go. There's an awesome platform out there. Let's sell it. They go out and they can sell. So it's $100 million in equity, and they sell that $100 million. All of them, they take a 25% discount. The entire fund can trade at a 25% discount. So if the whole thing trades for $75 million and yet the value is still going to be 100, fair market value is going to be marked up to 100, because that is how practical expedient makes it possible. Is it going to change? I don't see this changing. This is something investors need to be aware. Do I wish it could change? Absolutely. 100%? Yes. There has to be. So with public markets, we all agree, right? A company can jump up. A company can have a stellar day in the public markets, and the value can increase by 10%. Did the company increase in value by 10% overnight? No. But if I buy those shares, that is the value. That is my fair market value. It's the price I am willing to pay. In private markets, you don't have that. The fair market value is with those secondary stakes. It's whatever the fund manager marks it at. Regardless of what I buy it at, if I buy it at discount, that doesn't mean anything in private markets other than the fact that I can immediately recognize an unrealized gain. In an ideal world, there would be a mechanism where that data of what those stakes trade at is captured and taken into account. And if a fund trades very robustly at a very substantial discount, if a certain percentage of a certain fund trades at a massive discount, you know, there should be a way to account for. Maybe that's what it's worth. Maybe the market somehow is pricing it at a discount.
- [44:19]
B
So another disclosure issue that's come up recently is funds like Cliffwater Cascade Private Capital, where they're showing the cost of their holdings as a string of numbers in a footnote that's basically illegible instead of in a column where you can compare the cost to the current value. Do investors have any leverage to change those types of practices?
- [44:47]
C
I write about this, and I'm very public about this. How much I dislike this practice because I think it makes it very difficult to understand what those assets were bought for. And for those who have never seen that there are funds that disclose the schedule of assets will have fund xyz, cost, acquisition date, fair market value. Some funds disclose it that way. And you look at the schedule of investments and it's tallied up. Here's the total cost, here's the total fair market value, and it's really easy to decipher. Other funds will do a string of numbers in the footnotes, and it's 200 and it could be 275 holdings. And it's literally numbers separated by a comma. I have played around with, with AI, you know, to reconcile. And it's. It's possible and people do it, but it makes it very difficult for an investor or for an advisor who's evaluating those opportunities for their clients. It makes it very difficult to say, well, what are they buying? What are they paying? You know, are they buying a lot of assets at a very substantial discount? Are they. You know, there's no way to tell. That needs to be. If I could change that with a wave of a magic wand, if I could require that cost is clearly stated next to the asset on the schedule of holdings, I would love to see that.
- [46:17]
A
We've talked about the push to make private markets more accessible to retail investors. From a portfolio perspective, do you think adding exposure to private markets is likely to be a net positive for someone with a lower level of network? And if they do it, any thoughts on how they should size that position as a part of their portfolio?
- [46:37]
C
There are far more intelligent people than me who specialize in portfolio and allocation sizing, so I will defer that question to them. But I will say this. As somebody who has an allocation to private markets, I would urge investors and advisors to those investors, I would strongly urge them to think about liquidity needs. Because the one thing about private markets is that this position, like whatever positions you're in, they may not be liquid. You may be in an interval fund or a tender offer fund that offers periodic liquidity, and those funds may gate your redemptions and you may not be as liquid as you think you are. So an important thing there is to kind of have that conversation.
- [47:25]
B
On the research side, you've experimented with using several different AI tools and large language models to evaluate financial statements and annual reports. What have you found the most useful so far?
- [47:40]
C
My absolute favorite tool as it stands right now is NotebookLM. I don't know why it's not popular It's a free tool, it's available to anybody. It has a very high token limit right now. And what that tool allows you to do for my purposes, I can download a quarterly statement, I can upload it into that tool and I can chat with that tool about whatever is in that document. What's so brilliant about it is it limits its data source to whatever you uploaded. So it vastly reduces the amount of hallucinations. It doesn't pull random facts out of thin air, it doesn't lie as much. It's a fantastic screener tool to have in the toolbox. I will caution it does make mistakes. It is not a replacement for due diligence by any means, but as a back of the napkin kind of first pass screen, it does a fantastic job aggregating data. And for example, we talked about holdings and cost basis disclosed in the footnotes as a string of numbers I have played with. I'll feed that quarterly report and say, okay, reconcile those numbers, assume that they're done and whatever in chronological order. Reconcile them with a schedule of holdings and it does a pretty admirable job. It's not 100% accurate of course, but it can get pretty close. So fantastic tool. I highly recommend it.
- [49:16]
A
Last question. How about your must read books or other resources for yourself, but also investors and financial advisors more generally?
- [49:27]
C
Yeah, so I will recommend my favorite book. I read this when I was 19. It's Benjamin Graham's the Intelligent Investor. It's my all time favorite and I recommend it in the context of somebody who talks about private markets. And here's the reason why. The allegory that that Graham uses with Mr. Market and Mr. Market being irrational and selling you things that are worth more for, you know, at a discount at some times and asking more than they're worth or willing to pay more than they're worth at other times. I think that's a fantastic framework to kind of have in your head as an investor, as anybody who invests any sums of money. Here's why it's important in the context of private markets. In private markets you don't have that option. You do not have a Mr. Market who is willing to pay or you don't have an opportunity to buy assets at as much of a discount because of the valuation methodology. That's number one. And my second resource is I really like Howard Marks. He has an excellent book called the Market Cycles. I've recommended it to countless friends and fellow investors and I love his memos. I think they're available on the website. You can find them. They're beautifully written, they're very clear to understand, and they touch on a lot of timely topics.
- [51:00]
B
Well, Layla, thank you so much for joining us. We've only scratched the surface of potential topics related to this area, but it's been a super interesting and helpful discussion.
- [51:11]
C
Thank you for having me. It was a pleasure.
- [51:13]
A
Thanks again.
- [51:19]
B
Thank you for joining us on the long view. If you could please take a moment to subscribe to and rate the podcast on Apple, Spotify or wherever you get your podcasts. You could follow me on social media.
- [51:31]
A
Amyr on LinkedIn and @suouth1, which is Syouth and the number one.
- [51:39]
B
George Cassidy is our engineer for the podcast and Cary Grandchik produces the show Notes each week. Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us@thelongvieworningstar.com until next time. Thanks for joining us. This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording and are subject to change without notice. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. And its affiliates, which together we refer to as Morningstar. Morningstar is not affiliated with guests or their business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy or the completeness of the data presented herein. This recording is for informational purposes only and the information, data analysis or opinion it includes or their use should not be considered investment or tax advice and therefore is not an offer to buy or sell a security. Morningstar shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analyses or opinions or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision. Please consult a tax and or financial professional for advice specific to your individual circumstances. MorningStar Investment Management, LLC is a registered investment advisor and subsidiary of Morningstar, Inc. The Morningstar name and logo are registered.
- [53:29]
C
Marks of Morningstar Incident Sam.