Free Lunches & Groucho Marx

There are times when all the world's asleep
The questions run too deep
For such a simple man
Won't you please, please tell me what we've learned?
I know it sounds absurd
Please tell me who I am

• The Logical Song, by Supertramp

I’d Rather Be Lucky Than Smart

In my June 2024 newsletter, I discussed some common misconceptions about private investments. In particular, I analyzed their widely perceived benefits, both as a standalone asset class as well as within a broader portfolio context. Lastly, I discussed why it was likely that such investments would fall short of investor expectations on these fronts. Whereas I cannot say for certain whether I am smart or lucky, my prophecies have since come to bear.

This month, I will re-visit the driving forces underlying my past predictions. I will also take stock of where private markets currently stand with respect to these factors and related implications for the future.

The Magic Elixir: Who Doesn’t Want A Free Lunch?

With respect to constructing optimal portfolios, modern portfolio theory dictates that, all else being equal:

• Investments with higher expected returns should receive higher allocations than those with lower expected returns.
• Investments with higher volatility should get lower allocations than those with lower volatility.
• Investments with lower correlations to other asset classes which can lower overall portfolio volatility should receive larger allocations than their more correlated counterparts.
• Less liquid assets should be penalized for this shortcoming via lower allocations than more liquid investments.

Until recently, private assets had delivered exceptionally strong returns. Both private equity (PE) and private debt (PD) funds had far outperformed their publicly traded brethren. Another advantage of private over public investments that has become widely accepted is their relatively low volatility. Even better, just when it seemed that private investments couldn’t look more promising, they became widely viewed as offering investors yet another “sweetener” – low correlation to traditional stock and bond portfolios and a related capacity to smooth out overall portfolio volatility.

What rational investor wouldn’t want to load up on assets imbued with the holy trifecta of high returns, low volatility, and low correlation to stocks and bonds? As this alleged free lunch became increasingly accepted, it served as a lightning rod for new and/or higher allocations from endowments, pension funds, family offices, ultra high net worth investors, etc. And thus began the great stampede of capital into private markets. PE assets under management grew from roughly $1 trillion in 2010 to over $4 trillion by the end 2024. The private debt market has also grown at a parabolic rate, with assets under management jumping from $250 billion in 2010 to approximately $1.4 trillion today.

Everything Has A Price, Including Illiquidity

All else being equal, illiquidity is a bad thing for which investors should be compensated. In theory, private assets can make investors whole for this drawback with higher returns, low volatility, or low correlation to other assets. The trillion-dollar question is whether private holdings actually possess these qualities, and if so, do they offer them in sufficient magnitudes to compensate investors for tying up their capital.

Higher Returns? Don’t Bet On It

You cannot change the inexorable forces of supply and demand. When a small amount of money finds a previously underexplored market that is replete with attractive investment opportunities, it is relatively easy to deliver excellent returns. However, when trillions of dollars chase the same strategy, it becomes increasingly difficult to do so.

When an asset class becomes widely popular, it ultimately becomes a victim of its own success, which is congruent with Buffett’s observation that “What the wise do in the beginning, fools do in the end.”

Frankly speaking, it is beyond me how sophisticated endowments and pension funds could funnel trillions of dollars in PE and PD investments over the course of only a few years and not believe that their collective actions were fundamentally changing the market for such investments?

As sure as the sun rises, the combination of too much money chasing too few opportunities has coincided with a deterioration of the performance of private vs. public assets. According to Cambridge Associates, PE funds have delivered average annualized returns of 7.4% over the past three years ending June 30, 2025, as compared to 19.7% for the S&P 500 Index. In similar fashion, several large PD funds have faced significant write downs and a spate of investor redemptions (which often cannot be honored due to a lack of liquidity). None other than Blackrock recently reported a 19% decline in the value of its middle market private lending portfolio. The private goose has stopped laying golden eggs.

Diversification Value: Always Was And Still Is A Myth.

Whereas it might seem irrational for investors to lock up their money in private investments for 5-10 years without being compensated with higher returns, this need not necessarily be the case. To the extent that private assets are uncorrelated with stocks and bonds, the former can compensate investors via diversification value. Alternately stated, even in the absence of higher returns, it is logical for investors to assume private assets’ illiquidity on account of their ability to smooth overall portfolio returns. That having been said, the notion that private assets are uncorrelated with their liquid, publicly traded counterparts always was and remains a complete farce.

From a high level, private assets experience the same business cycles, competitive pressures, and market forces as their public counterparts. Furthermore, it stands to reason that companies with greater leverage should be more volatile. On average, PE firms take on 100%–200% debt for every dollar of equity, as compared to 50% for publicly listed firms. And yet, PE funds have consistently managed to exhibit far lower volatility than most public equity portfolios.

According to Sherlock Holmes, “When you have eliminated the impossible, whatever remains, however improbable, must be the truth." The magic behind private assets’ optically low volatility lies in their lack of regular, mark-to-market pricing. Rather, the values of private holdings are based on somewhat subjective, self-reported asset values. This practice, which has been dubbed "volatility laundering”, explains the sleight of hand by which private asset managers artificially smooth their returns.

When Blackrock marked down the value of its middle market private loan book by 19%, I am pretty sure that this was not due to some adverse developments that had transpired over the prior week, month, or quarter. Rather, it likely stemmed from an issue that had been festering for a far longer period, but was masked by the ability and willingness to smooth returns and create a mirage of stability. As is common practice in the industry, Blackrock had been taking painkillers for a broken leg. The injury was always there but investors couldn’t feel it. When the drugs wore off, the pain hit all at once. While I am not suggesting this practice is fraudulent, it does create a misleading illusion of stability and overstates the diversification potential of illiquid holdings.

Importantly, I have little doubt that in the event of a prolonged bear market in stocks or bonds, PE and PD portfolios will experience some fairly extreme pain, thereby failing to deliver their purported diversification benefits precisely at a time when they are most needed.

Echoes Of Groucho Marx

Now that I have (hopefully) dispelled the low volatility and correlation myths with respect to private assets, the remaining question is whether their future returns will be sufficiently higher than their public equivalents to compensate investors for their relative opacity and lack of liquidity. In my view, it is unlikely that this will be the case.

The meteoric rise in assets under management across private fund managers has created an adverse, structural imbalance between the demand and supply. The amount of capital in the private system has grown far too large relative to the supply of attractive opportunities, thereby dampening future return prospects. Moreover, the number of unsold PE assets stands at a two-decade high, with more than 31,000 unsold companies globally.

Furthermore, the PE industry has benefitted tremendously from nearly 40 years of declining interest rates and the related use of cheap leverage. Not only have higher rates eliminated this source of return, but higher rates also have the effect of lowering exit multiples on PE investments, which has and will continue to further dampen performance.

Another reason to suspect that private asset managers’ returns will be lower going forward is that their incentives have changed. The smaller, more nimble managers of yesteryear were incentivized to deliver strong returns to maximize performance fees.  In contrast, today’s behemoths are motivated to maximize assets under management and management fees. The name of the game is to raise as much money as possible, invest it as quickly as possible, and begin raising money for the next fund. The objective is no longer to produce the best returns, but rather to deliver acceptable returns on the largest asset base possible. As the great Charlie Munger stated, “Show me the incentive and I’ll show you the outcome.”

The so called “smart money” appears to be well-aware of these headwinds and is heading for the exits. Most of the Ivy League endowments are reducing their exposure to private assets. Equally as telling is their willingness to liquidate holdings at a discount to their reported values in exchange for liquidity.

Groucho Marks famously stated, “I wouldn’t want to belong to a club that would have me as a member”. Private investments are generally not available to the general public. Rather, the private asset “club” is largely restricted to wealthy individuals, family offices, institutions, endowments, etc. Given the current state and future prospects of private markets, even if the club would have me, I wouldn’t want to be a member.