Private Fund Gains Might All Be Artificial—and AI Has Nothing to Do With It

On this episode of The Long View, Leyla Kunimoto, founder and editor of Accredited Investor Insights, discusses how investors can understand performance in private markets, what investors should worry about when it comes to disclosure, and what she thinks needs to change when it comes to the standards for secondary funds.

Here are a few excerpts from Kunimoto’s conversation with Morningstar’s Jeff Ptak and Amy Arnott.

How Secondary Funds Can Manipulate the NAV to Artificially Generate Returns

Amy Arnott: I wanted to follow up on the secondary funds that you mentioned can be a positive thing, and 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 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?

Leyla Kunimoto: With all my heart, I do. I do think that practice—that needs to change, the accounting standards need to change, and more disclosure needs to be done about it. And we’re touching now on a very big topic, an overarching topic: How are valuations in private markets arrived at? And with secondaries 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 secondaries fund comes to 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 secondaries fund buys this 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 the $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’re going to a car dealership, buying a car for $45,000, a below invoice price, but you come home, and on your own balance sheet, you say, “OK, I bought a car for $45,000, but the sticker on that car was $52,000. 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.

We can record another two-hour podcast about valuations, but that is—the secondaries funds show these gains, and there’s 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 on the overall structure.

So that’s playing out right now. There are a lot of secondaries 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 semiliquid, right? They’re not super liquid funds, but there’s an option to redeem your shares. And they are a very popular product. There are a number of them.

Why Investors Should Be Wary of Secondary Fund Managers Choosing Their Own Fair Market Value

**Jeff Ptak: **So maybe if I could just jump back to your example, the NAV of the private equity sort of investment is $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, right? And so 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?

Leyla Kunimoto: With the public markets, if I buy a share of a company at a discount, the 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 what I’m willing to transact with another willing party? And this boils down to that. So, I will give you a roundabout answer, but let’s say a primary fund, a fund that holds private equity firms, right? It’s a primary fund; they invested directly into those companies and have 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 will collude, and they say, “Hey, you know what, we want to exit this. 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 million, the fair market value is going to be marked up to $100 million, 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 of. Do I wish it could change? Absolutely. 100% yes. 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. So, if I buy at a 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 the 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, there should be a way to account for, maybe that’s what it’s worth. Maybe the market is somehow pricing it at a discount.