“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually and then suddenly.”Ernest Hemingway
Let’s talk about markets and price signals. Don’t worry, this is simple stuff.
If something doesn’t sell, and you want to sell it quick, what do you need to do?
That’s right - lower the price!
Told you this would be easy.
Now this hypothetical thing that you want to sell… if you are asking too much money for it, nobody will buy it, right? That seems pretty simple.
Let’s say there’s this other hypothetical thing that you might own with thousands of other people. Let’s say that this hypothetical thing is… oh, I don’t know… a portfolio of mortgage loans.
Now let’s assume that you are telling your fellow investors that one unit representing their interest in this portfolio of loans is worth $1000. But a large number of these people believe that the value of these loans is declining quite rapidly. What might these people do?
That’s right, they will cash out their investment unit at the $1,000 you are telling them it’s worth.
If enough people do this, you might have a problem. Because these loans do not trade on a public market, it will take time to find someone to sell them to. If you have to sell quickly, you might have to reduce the price and take a loss on your portfolio. It’s even worse if a bunch of these borrowers are behind on their payments. And so what you can do is tell your investors “sorry, but you can’t get your money just yet, please be patient.”
And this is all fine, except you are still claiming that their investment is worth $1,000 per unit.
Is it really?
You won’t give your investors $1,000 for their units.
I wouldn’t be willing to pay that much for one of these units. Would you?
Here’s the crazy part - all of these investors are going to get investment statements showing the value of these units at around $1,000. This is a lie. Everyone involved knows it’s a lie. And yet, this is often how things are done in the private investment sphere.
The managers of these investments market them as “low volatility” and “uncorrelated with public markets,” but this is only because, as illustrated above, they are slow to adjust the “price” of the units.
Because the funds don’t trade on a public market, investors don’t see the price zigzagging around every day and assume the investments are doing just fine, even as dangerous cracks are forming beneath the surface. Cliff Asness of AQR Capital calls this “volatility laundering.” I devoted a chapter in Low Risk Rules to the idea, with the title, “The Volatility You Can’t See is Still There.”
In late 2022 I wrote: “If you’ve been paying attention, you might be noticing that recently, the cracks are starting to make their way to the surface.” What’s the situation in early 2025? The patient is still alive, but much worse for wear.
Way back in 2022, one of Canada’s largest private mortgage lenders, a fund that promised investors high single-digit returns, had taken steps to limit redemptions from its flagship fund. So investors who wanted to redeem units had to get in line behind other investors who have already asked for their own money back.
The manager was slow in updating their website. At the time I wrote my piece, if you were wondering how the fund had been performing year to date, a visit to their website showed that for the first three quarters of this year, it was up 8.3%. Nothing to see here!
Were you willing to believe that the value of your investment was up 8.3% in 2022, even though the fund didn’t have the cash to redeem your units?
I criticized the fund’s brazen marketing, which had the audacity to show you a graph demonstrating the “stability” of their returns since 1997, versus stocks and bonds.
Speaking of audacity, if you wanted to donate to the cause of helping existing investors get their money back, the manager conveniently linked to subscription forms for new investors. You were free to buy into the fund at the same price at which they refuse to redeem existing units. So there’s that.
So where are we today? Well, the offending return statistics have been removed from the site, nowhere to be seen. Return info is still available, but finding it requires you to click through to PDF reports and flip through looking for the relevant data. They have also seriously shrunk the financial history on display in their graphs, all the better to hide the decline since the fund peaked in 2022.
This is a chart I pulled from the most recent report. The Fund’s trailing 12 month returns are on the left, as compared to Canadian bonds (the middle bar) and stocks (the bar on the right). Hard to spin this as anything other than a failure.
The point I wanted to make wasn’t to pick on a manager going through a rough patch. My goal is to make sure investors understand is how private market investments hide volatility from your sight. Some investors actually prefer this, because it keeps them invested through rough periods. But realize that if this is your viewpoint, you are essentially paying your private market manager to lie to you.
I referenced an article from The Economist that covered this topic, asking: “has private equity avoided the asset-price crash?” I’ll skip to the article’s last line: “soon private-fund managers will have nowhere to hide.” In between the article discusses the many ways that private equity managers can “smooth” returns over time, further adding to the obfuscation of what’s really going on in your portfolio.
And yet, the hawkers of “prestige investments” will tell you that the fund values have not been marked down because the issues currently faced by these managers are “temporary,” “transitory,” and simply put in place to avoid having to sell assets into a declining market. Fair enough, but I bet a lot of investors in this particular mortgage fund wished they were able to cash out back in 2022, because since then, it’s been dead money.
Investors in private assets need to realize that in they are not getting the full truth of what’s happening to their investments, lulling them into a false sense of security. If markets stabilize and recover, investors will be none the wiser. But if they don’t, they could just be setting themselves up for a violent reckoning down the road.
But that’s a topic for another essay… in fact, it’s one I’ve already written. If you have a copy of Low Risk Rules, check out the story about Southland Royalty in Chapter 11 (under the heading Gradually, Then Suddenly). It serves as a cautionary tale for what might be awaiting today’s private equity investors.