I used to think that plug-in hybrid electric vehicles were the perfect solution. They have enough battery life for city driving and no range anxiety for longer trips.

I thought this until a friend in the auto industry pointed out that hybrids are the worst of both worlds. They’re more expensive than gasoline-powered cars, have a battery that degrades, are heavier so highway mileage is worse, and the costs of tires and brakes are higher. They also still require oil changes and maintenance, like gas-powered cars.

I haven’t totally bought into his argument for cars yet, but for something I know far better, investment products, he’s spot on. There are plenty of products that are hailed as being the best of both worlds but are below average in both (I’ve written previously about index-linked notes).

The analogy is relevant for the new darling on the investment landscape: private assets. As private funds open their doors to individual investors, they may be heading down a similar path to hybrid mediocrity.

Private is where it’s at

First, some background. I’ll focus on private equity, which has served institutional investors and wealthy individuals well for decades.

There are many attractions to private investing. Investors get access to assets not available in public markets, and by sacrificing liquidity, they have the potential to earn higher returns (known as an illiquidity premium). Fund holdings are also valued less frequently, which smooths out returns and provides diversification.

For fund managers, it means guaranteed capital for 10-plus years, which allows them to operate outside of the public eye. They can use more leverage to enhance returns and reduce taxes, and they can make changes without worrying about quarterly earnings calls – disruptive things such as management changes, restructuring, new operating systems or acquisitions.

There’s a lot to like, but do these strengths hold for the private equity funds being offered to smaller investors?

Unlocked and opened up

It’s not yet known whether these retail funds will use less leverage and/or be required to do more quarterly reporting. Almost certainly there will be more regulatory and adviser scrutiny.

The biggest compromise will be liquidity. Funds designed for individual accounts need to be open ended to allow for flows in and out. This is a critical difference considering the huge advantages that go with permanent capital, and it creates a mismatch – illiquid assets in a liquid fund.

Open-ended funds can take precautions to manage the mismatch. To provide liquidity and protect the capital base, they usually hold liquidity sleeves that invest in publicly traded securities that can be sold to raise money. They also have redemption rules (how much, how often and how much notice) to discourage active traders.

When investors start lining up to take money out, however, the game totally changes. Long sleeves suddenly feel like short sleeves, and fund managers are forced to take two unpleasant steps: close or limit redemptions and sell assets at an unfavourable time. I’m sure managers who deal with long redemption queues, such as Romspen, Hazelview Investments and KingSett Capital, would prefer to be buying instead of selling.

Bumpier ride

For open-ended funds to be fair to buyers and sellers, prices must be current. A delayed pricing mechanism doesn’t work. The more often investors can transact, the quicker assets need to be repriced and, thus, the more exposed funds are to the whims of investor sentiment.

I haven’t mentioned cost, but suffice it to say an already expensive endeavour, private investing, will be more expensive. Accessing small investors is costly and comes with more mouths to feed.

Due diligence

Private assets make sense for institutions and wealthy families, but the jury is out on how they’ll work for smaller investors who don’t have the same resources and clout. Undoubtedly open-ended structures water down some of the advantages that institutional investors count on.

If you want to invest privately, pay attention to the structure and who you’re investing with. It pays to be contrarian. Look for funds that offer limited liquidity, at least in the initial years. The tougher the exit, the fewer performance chasers you’ll have with you and the more effective your manager can be. If you want to avoid hybrid mediocrity and capture that valuable illiquidity premium, make sure your investment is truly illiquid.