The Ontario Securities Commission is attempting to do something that’s harder than finding ice cream without calories or building a great relationship without compromise. It’s exploring how best to bring private assets to individual investors.

Before I explain the challenge, some background.

Go private, young man

Funds investing in private assets offer the potential for higher returns if investors are willing to make a long-term commitment. It’s known as an illiquidity premium.

As a recent article in the Report on Business pointed out, there’s pressure on the Ontario Securities Commission to approve this new category of funds for broader distribution because private markets are now a large part of the investment landscape. Companies are staying private longer and growing to be very large, while the number of publicly traded companies is in decline.

The pressure is coming from both industry and government. Managers of private equity and debt, along with infrastructure and real estate, desperately want access to a big, untapped market, individual investors, and the federal government wants to see Canadians provide more long-term capital to build infrastructure and support innovation.

Clink, clink, clunk

It all sounds good but there’s a giant elephant in the room – the liquidity mismatch. There’s no way around it. Putting assets that are not easily tradable in funds that investors can move in and out of is a huge mismatch.

Investing in private assets requires long-term capital that allows fund managers to buy unique assets, fix them up, scale them and then sell them opportunistically. They need to know the capital will be there while doing that.

Without that assurance, managers are forced to water down their process – keep more cash in reserve; use less leverage; forego opportunities that will take years to play out; and at times, be forced to sell when they’d rather be buying.

In private funds that offer redemptions, everything works well when markets are good and more money is coming in than going out. But if the worm turns and investors are queueing up to redeem, however, the cash reserves suddenly look too small, and investment strategies go out the window. Like good publicly-traded companies, private funds can get through tough times and come out the other side even stronger, but not if the recovery time is cut short.

Imperfect solutions

The OSC is looking for an unattainable balance that requires fund managers to offer more client-friendly products and buyers to understand what they’re getting into. It’s unattainable because if they put too much emphasis on constraining managers, investors will get a watered-down product that has little hope of meeting its promise. It’s already hard enough, and costly enough, to generate extra returns, without the challenge of uncertain capital, restrictions on leverage and diversification, and the additional cost of compensating advisers.

In my view, the compromises should mostly be on the client side, these ways:

• Make it harder. Buying a private fund shouldn’t be as easy as an ETF or mutual fund. There needs to be symmetry between buying and selling. If it takes months or years to get out, after notice periods and redemption limits, buying should also have extra steps that signal what’s ahead. That’s certainly been my experience with private investments. The paperwork and lawyers are painful, which always prompts me to ask, is this worth it?
• Restrict liquidity. The OSC shouldn’t assume that investors need monthly liquidity. Indeed, illiquidity should be positioned as a benefit, not a detriment. After all, it’s an illiquidity premium, not discount. If investors want the returns, they have to give up something. Certainly, if I’m buying, I want to know that my fellow investors are in for the long haul. Otherwise, I have no interest.
• Clearly state the consequences. Institutions have a safety value. They can sell their private holdings to other investors in the secondary market at a discount to net asset value.  Individual investors should also be penalized for changing their mind. Perhaps, something like this: If they want out in 30 days, the price is discounted by 20 per cent, with the foregone value staying in the fund to compensate the remaining unitholders. After one, two or three years, the discount goes to 10 per cent. And so on – the shorter the notice period, the larger the discount. Like GICs, investors can get their money back any time, but there are consequences. 

If investors want to access private assets and earn an illiquidity premium, they need to be the ones to compromise. These funds belong in a different bucket than their bonds, stocks, ETFs and mutual funds. For individual investors, it should be labelled: “Don’t touch.”