Investors face up to private funds’ illiquidity as rates rise

After searching for yield in private investments during an extended period of low interest rates, some investors are learning that illiquidity is more than hypothetical.

“It was a rate-driven bull market for real estate and for the credit associated with real estate, and that provided large returns for many years,” said Jamie Price, portfolio manager with Richardson Wealth in Toronto.

But as interest rates climb at a vertiginous pace, some private real estate funds have restricted redemptions.

“I think we’re at the beginning of understanding how higher cost of capital is going to affect the business models that are behind some of these real estate projects,” Price said.

Late last year, Blackstone Inc. limited withdrawals from its flagship US$69-billion private real estate income trust (REIT) after redemption requests hit the fund’s pre-set limits — a practice referred to as “gating.” In Canada, private mortgage lender Romspen said it was freezing redemptions, citing economic conditions and “unusually elevated investor demands for liquidity.”

While such measures shouldn’t surprise experienced investors, those who went into private funds when interest rates were near zero may face a rude awakening. Some market watchers have cited the moves as a broader warning sign.

“The problem is people were seeing these consistent, attractive distributions during sanguine times. Now they’re freaking out,” said Athas Kouvaras, client relationship manager with Richter Family Office in Toronto.

Because private assets aren’t marked to market the way public investments are, Kouvaras said, they may feel less risky because there’s an “artificial smoothing of volatility.”

“That maybe makes you feel good, but if you actually believe it’s low risk — well, it’s not,” he said.

Some funds do quarterly appraisals of their assets while others are conducted annually. And those valuations can change significantly based on market conditions, creating a lag effect. As a result, most private funds’ strong returns held up last year while public REITs tanked alongside other public securities. As of Jan. 25, the Dow Jones U.S. Select REIT Index was down by 16.8% on a one-year basis. The S&P/TSX Capped REIT Index was down by 7.3% for the same period.

“With the lack of mark to market, people will want to sell because [their private fund] appears high compared to other asset classes they own that are lower,” Price said.

Loren Francis, vice-president and principal with HighView Financial in Oakville, Ont., said it’s not surprising to see some investors “running for the door.” With the dramatic rise in interest rates and a recession potentially on the horizon, more private investments could be affected.

“It’s inevitable when you run into market conditions like we have there are going to be shocks to the system,” Francis said.

It’s up to advisors to explain those shocks and manage client expectations.

“You need to understand that there isn’t a set of buyers on the other side,” she said. “There’s one buyer. If things get tough, they’re going to have that ability to gate or to defer redemptions. You should expect that if markets go into a pullback or we go into a recession that those mechanisms will go into place.”

In its November redemption deferral notice, Romspen said “the life cycles of the fund’s underlying assets and the capacity to generate strong returns for investors has always necessitated a trade-off with the ability to demand immediate liquidity.” The firm remained “confident in the underlying value of the fund’s assets.”

Kouvaras said it’s important for advisors to be consistently upfront about private funds’ illiquidity and prepare clients for negative scenarios: “I think it’s good psychologically to keep reminding people — ‘Yes, it’s doing well. Yes, it’s paying out. But remember, if we have a rough patch, they could gate.'”

Investors tend to react negatively to paused redemptions, but those measures are “there to protect you as an investor, as well,” Francis said.

As with all asset classes, a bear market exposes risks managers were taking. Price said a separation may begin to appear between private asset managers who knew what they were doing and those who were “riding the tide.”

For example, some private REITs may have continued to have floating-rate loans going into 2022 because they were cheaper and made the fund look better in the short term, but are paying the price now.

Advisors should examine the models funds use to value their assets, Price said. Some use market measures like the capitalization rate and apply it to their portfolios, while others have third-party appraisals at certain intervals.

“I’m more interested in the consistency with which they apply those models than I am about the models themselves,” he said.

For example, advisors should make sure funds use the same appraiser and the same metrics as the previous period.

What now?

In addition to concerns about valuations, investors in private assets may simply be reducing their allocations to rebalance portfolios after public securities dropped last year — known as the denominator effect. Some clients may also have leverage elsewhere as they deal with higher interest rates, Price said, and therefore want liquidity in their investments.

“If you’re looking at alternatives going forward, given where interest rates are, is there enough of a premium in some of these alternative investments?” Francis said. “What is it you’re getting from alternative investments? You want to look long and hard at that.”

Private investments still have appeal, however. Price likes the psychological benefit of minimizing mark-to-market volatility, and Francis said a long-term view is appropriate.

“As long as you’re invested in something that might have a little bit of volatility but not significant issues, you should be in it for the long term and hold on,” she said. “Most of these things should come back with time.”