The risks behind retail investors' fervor for private markets

After a credit scare chilled some investors last month, financial advisors and their clients have even more reason to be skeptical of the claim that retail portfolios need more private assets.

The collapses of car parts supplier First Brands and subprime auto lender Tricolor came before some momentary shivers from two large regional banks' disclosures of losses from alleged borrower fraud. Banks have sought to reassure investors concerned about the potentially ignored risks related to the massive rise in private credit and investment vehicles linked to it by casting their spooky disclosures as isolated, one-time events. And planners know how to advise clients to harness outsize returns in private equity and other nonpublic assets that come with higher fees while avoiding those that charge high costs for returns that are ordinary or worse.

But sales pitches and government policies seeking to "democratize" private assets through 401(k) plans and other retail portfolio holdings are reaching into every part of the wealth management industry. Some of the alternative investment assets that could gain access to non-accredited households' portfolios understate their volatility and underperform the private vehicles available to wealthier clients, according to a working research paper posted this summer. 

At a minimum, the calls for "giving access to these funds to people who have really only dabbled in the public markets" are "getting a little risky now," said Dinon Hughes, a partner at Portsmouth, New Hampshire-based registered investment advisory firm Nvest Financial and a member of this year's class of Financial Planning Rising Stars. "There's a reason that these things have been private before, because there's a lot of education that has to go into understanding them."

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A momentary blip or a cause for concern?

That fact came into sharper focus last month, when JPMorgan Chase reported that it was absorbing a hit of $170 million to its credit based on exposure to Tricolor. The megabank is reviewing its underwriting procedures in light of the lender's bankruptcy protection amid allegations of fraud, CEO Jamie Dimon said.

"My antenna goes up when things like that happen," Dimon said on the firm's earnings call. "And I probably shouldn't say this, but when you see one cockroach there are probably more. So everyone should be forewarned at this point."

After a brief interlude of losses for major stock indices and expressions of confidence from executives with Zions Bank and Western Alliance Bank in their overall credit portfolios, equities have more than recovered the value they lost. But some see lingering reasons for fear.

"It's fair to get one's spidey sense tingling a little bit, but it's not necessarily fair to assume the worst right now," Interactive Brokers Chief Strategist Steve Sosnick told CNN Business last month. "If this is more of an infestation, to extend Jamie Dimon's analogy, the market's not ready for it."

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Study says BDCs deserve caution

With that backdrop, the study by Ben Bates, a research fellow at the Harvard Law School Program on Corporate Governance, built a compelling case for further caution, especially around the asset type that is the focus of the paper: business development corporations. The investment products linked to financing providers for struggling, small private or public companies have always received scrutiny. The Securities and Exchange Commission's Office of Investor Education and Advocacy issued bulletins about BDCs on public markets and the nontraded version of them last year.

Faced with the long-standing difficulties of tracking data on private investments, Bates evaluated the returns of the small group of nontraded BDCs that also have a version of their product available on public exchanges by comparing their yields.

"An index constructed from these funds' traded shares has more than four times the volatility of an index constructed from returns based on their [net asset value]-based reported returns," he wrote. "I use these publicly traded BDCs to calibrate a statistical model that I then use to estimate what returns would look like for non-publicly traded BDCs if they tied their investment valuations more closely to public market fluctuations. These simulation results suggest that, if non-publicly traded BDCs made this change, their risk-adjusted performance would flip from being more attractive than the public stock market to less attractive."

Bates acknowledged that his conclusions, which were based on a small sample from a vast universe of trillions of dollars in private assets, were tentative. But his simulation and accompanying dive into the available filings pointed to two risks that advisors and other experts may have known all along: Retail investors could be getting lower-quality products than those available to wealthy households, and the lack of disclosure in private markets could "set retail investors up for unpleasant surprises," Bates wrote in the conclusion.

"Investors may discover during a downturn that they have taken on more risk than they anticipated or that their investments are less accessible than they anticipated," he wrote. "Given the risks inherent in the expanding class of retail private funds, I call on regulators to make thoughtful reforms to the regulatory and disclosure frameworks governing these funds. By improving the reporting of market-based asset valuations and fund fees and by streamlining the menu of legal structures available to sponsors, the SEC can give investors the tools they need to make wise decisions without choking off innovation in this burgeoning area."

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Alternatives to alternatives?

Regardless of those warnings and the predictable industry pushback against them, retail investors "see the opportunity, and that's bigger dollar signs, bigger returns in private markets," Hughes noted. At an estimated $1.9 trillion that is expected to reach $3.7 trillion by 2029 through advisors' allocations to private market strategies on behalf of retail investors, they could be hearing from clients about any number of products promising hefty returns.

"As more people get access to these private investments, they become less lucrative just due to the nature of it," Hughes said. "I expect it at some point to swing back the other way. … The pendulum will swing back the other way to public markets."

If a client came to Hughes asking about a nontraded BDC, he said he would ask them why that product in particular appealed to them. Then he could point out the possible shortcomings of assets that tend to bring much higher costs, low liquidity and little transparency for investors, along with other methods that might achieve similar goals.

"If you ask them, the response is probably because, 'I think it will get a better return,'" Hughes said. "Then maybe it is a good fit, but, maybe nine times out of 10, it's probably not the best one for them at the end of the day."