Private funds are generally a pooling of investors’ assets into a fund that an investment manager takes to invest in different asset classes. These private funds often invest in illiquid investments, including real estate, non-publicly traded companies or special debt/bond agreements. Historically, these private funds were only available for higher net worth individuals that met certain net worth or income levels.
There has been a trend for larger investment managers to try to offer private funds to non-high net worth investors. Some funds would offer entrance into these private funds down to $5,000 minimums. To entice investors even more, they would allow you to redeem your capital on a monthly basis, maybe even sooner. So think about it. You are investing in private investments (real estate buildings, etc.) that are illiquid (you can’t buy and sell it on a daily basis), but the fund manager is providing you better liquidity than the investment itself. Too good to be true?
Yep.
Recent Redemption Lockup of Large Private Real Estate Fund
Recently there was a very large non-traded real estate investment trust (REIT) invests in private real estate that started to have large redemption requests. To avoid potential issues with the fund, the investment firm had to slow redemptions, locking current investors in the fund more so than the investors originally signed up for. The fund is managed by a very well known, successful investment firm. The fund had a redemption policy that allowed investors to redeem on a monthly basis and did not have any issue meeting redemptions requests in the past.
Fast forward to today, and as the global real estate market slowed significantly, and publicly-traded REITs sold off significantly, investors in this private real estate fund appeared to start increasing their redemption requests. As redemption requests quickly increased, the fund manager needed to halt withdrawals on the fund even more, potentially trying to avoid a “run on the bank”.
Side note: With publicly-traded REITs down over 20% this year, and the private real estate fund’s valuation still positive for the year, that was a huge discrepancy. Any knowledgeable investor may want to book profits in the private fund with the still high value and potentially reallocate to the public REITs that have declined significantly in value. Buy low, sell high. This may be one reason for significant outflows for this large private real estate fund. Private real estate funds can value their own assets, and may be “hesitant” to reduce their valuations on their investments.
Remember, the fund invests in illiquid real estate. It tries to meet redemption requests from income generated from its real estate investments and can manage redemptions from the fund with contributions into the fund. It’s just a cash flow management strategy. In this case, cash outflow requests overwhelmed any cash contributions and income generated from the real estate. To meet redemptions further, the fund managers would need to sell properties to generate additional cash.
Think about it, trying to sell illiquid real estate in a down real estate market potentially fire sale prices, angry investors, more redemption requests, more fire sale prices and a collapse of the fund. Since the underlying real estate properties are probably fine, being forced to sell for no fundamental reason is a huge issue that no investment manager wants to get into. Thus the fund slowed redemption requests accordingly.
Outside of this particular scenario, I have seen other private funds and even daily liquid mutual funds get caught in the liquidity mismatch: providing more fund liquidity than the liquidity of the underlying investments. In these scenarios, the value of the funds fell dramatically and investors were stuck holding onto their positions for years. What a bad place to be for the potential of so-called added returns from the “illiquidity premium”.
Summary
Remember, private funds that invest in illiquid securities should be considered illiquid themselves, regardless of what the fund manager says. Do not expect to get out of your investment in a private fund at anytime. You really need to determine whether or not locking up your capital with the potential of not getting it out anytime soon (maybe when you most need it) is worth it.