Hidden Risks of Investing in Private Markets Through Investment Clubs and Personal Networks

Private markets can be incredibly inefficient. They are often rife with information asymmetry, adverse selection, transaction costs, limited price discovery, and illiquidity. Inefficiencies are typically further exacerbated in niche categories and lower-middle markets.

Common access channels to private markets include private banks/RIAs, family offices, and a blend of investment clubs/personal networks. Private banks/RIAs predominantly focus on scalable blue-chip exposures, often overlooking niche, smaller-scale opportunities ripe with potential for excess return—a space where family offices generally shine. But family offices are uneconomic for ~99.9% of the population. This market dynamic drives many individual investors to access private markets via investment clubs/personal networks, which are herein referred to as ‘informal channels.’

Informal channels may be characterized as ‘community-driven,’ powered by compounded network value and intellectual capital (assuming the network is high-quality). Smaller investments are aggregated to augment bargaining power to create ‘value’ for the collective whole. Such benefits are often touted as a core reason to invest with the crowd—and the benefits of strategic networks and shared intellectual capital are legitimate. However, the noise of the crowd often drowns out a key issue.

Most informal channels lack a dedicated investment team or centralized resources.

When an institutional firm invests in a company or a piece of real estate, for example, it generally conducts rigorous due diligence. Depending on the asset class, this often entails a quality of earnings report, audits, operational due diligence, underwriting, background checks, reference checks, legal review, and so forth. These costs vary widely. But there’s one common trait across large-scale institutions, it’s typically not optional. Fiduciary duties apply, and so, if one was to invest $10 million in an emerging company to, let’s say, fuel growth, most would deem it prudent to conduct such diligence.

We estimate due diligence costs to run around $100K - $300K (see Exhibit 1), equating to 1 – 3% of the hypothetical investment basis, which might be reasonable. At a $100K investment, less reasonable, and likely not feasible. These costs can be materially higher for certain transactions.

With pooled vehicles (e.g., funds), institutions typically conduct similar due diligence, but often with a different flavor, in an attempt to mitigate a different set of layered risks: fraud, self-dealing, conflicts of interest, and so forth. Meaning there’s incrementally more due diligence work to be done.

Why is it, then, that when informal channels aggregate smaller tickets, they tend to conduct less due diligence?

Usually because there’s no team, no centralized resources.

A dedicated investment team is not monitoring, reporting, and overseeing the underlying GPs managing these funds. These are costs informal channels often do not, or cannot, bear. It’s simply uneconomic in most cases.

That’s a major problem.

The psychological safety of the crowd can smoke out the perceived need for rigorous diligence, exposing individual investors to preventable (or discoverable) risks, despite the benefits of their aggregated capital. These channels then often spawn a reliance on ‘proxy’ diligence. (We all know how that turned out with the FTX saga, Madoff, etc.).

Rather than dedicate resources to risk mitigation and due diligence, many informal channels market their ability to negotiate fee discounts. And, in some instances, even receive compensation from GPs to market their offerings.

Paradoxical, right?

The allure of a lower fee schedule may be psychologically soothing, but it will not change the outcome of an underperforming investment. And ‘pay-to-play’ distribution/access for GPs will often serve to expose investors to adverse selection.

"When you are considering an investment in a capacity-constrained opportunity with a specific exposure, the fee schedule is not going to have a material impact on the outcome. Focus on the opportunity and the ability of the investment partner to execute the strategy." - Michael Leffell, Founder & Chairman

Due diligence aside, private markets are a vast ocean of a seemingly infinite number of opportunities to sort through (see our piece on vetting investment partners here)—more than 28,000 GPs and endless independent sponsors/one-off co-investments.

The best deals can be devoured very quickly, or pre-sold, by larger-scale investors who have dedicated teams proactively nurturing relationships and sourcing deals, in essence, to get a seat at the table when attractive opportunities arise. The often more defensive, reactionary posture of informal channels, then, heightens exposure to adverse selection. A scattered, or non-existent, mandate can exacerbate this problem.

The lack of a track record diffuses performance accountability and invites many different forms of bias. Informal channels often have a natural gravitational pull to focus on their winners (survivorship bias), place too much emphasis on current deals (recency bias), and are subconsciously or consciously motivated to do certain deals, either to ‘support’ members of the community, or fund their operations (confirmation bias). ??

The result? More information asymmetry and poor investment performance lingers in the underbelly of the crowd.

The common denominator with informal channels is that it’s often uneconomic to perform thorough due diligence, they can lack performance accountability, there may be too much ‘trust in the crowd’, limited, or no, centralized resources, and incentives tend to be completely misaligned—which can all result in unseen risk of adverse selection and fraud.

Here’s a few questions that may be helpful in guiding your approach:

• Are interests aligned? Who is getting paid and for what? Is the investment partner paying to market the deal (poor quality signal)? Are the key principals investing their own capital in the offering?
• Why am I seeing this deal? Identify why the investment partner is raising capital through your access point, is it because large-scale institutional investors passed?
• Who is negotiating terms? Is the individual or team responsible for negotiating/reviewing key terms sophisticated and well-positioned to identify key risks?
• Who is monitoring this deal post-close? Is there a team in-place, or resources dedicated to monitoring performance and engaging with the underlying investment partner?
• Who is driving this investment decision? Are the principals responsible for sourcing/signing-off on the investment experienced? What is their prior track record?
• Does the access channel have a track record? If not, why? How will they be held accountable?
• What was the due diligence process and who conducted it?

Investing is not best done as a hobby.

When sourcing investments through these channels, strongly consider risks associated with adverse selection, lack of oversight/governance, fraud, and potential conflicts of interest/biases.?

LPs should be proactively engaging with GPs to investigate appropriate oversight/governance in areas of alignment, risk controls, related party transactions, assessing key assumptions/value drivers, and conflicts. Without a dedicated investment team, again, it’s somewhat challenging to do this.

A community can be leveraged to harness the power of shared intellectual capital and high-value networks, but there’s no substitute for a dedicated investment team.

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This material is solely for informational purposes and should not be viewed as a current or past recommendation or an offer to sell or the solicitation to buy securities or adopt any investment strategy. The opinions expressed herein represent the current, good faith views of the author(s) at the time of publication and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this article has been developed internally and/or obtained from sources believed to be reliable; however, 10 East does not guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions, and other information contained in this article are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and 10 East assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward-looking statements. Individual investor portfolios must be constructed based on the investor’s financial resources, investment goals, risk tolerance, investment time horizon, tax situation and other relevant factors.?Investors should seek advice from their investment, legal, tax and/or other advisers to review their specific information.?Asset allocation does not guarantee a profit or protection from losses in a declining market. Investments in securities involves significant risk and has the potential for complete loss.