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Make sure it’s not too good to be trueMartin Pelletier: You don't need to avoid private markets entirely, but don't treat them as simple add-ons to traditional portfoliosLast updated 1 day ago You can save this article by registering for free here. Or sign-in if you have an account.Part of the appeal of private investments lies in what is not seen, because without continuous market pricing the volatility appears muted and the return profile looks smoother, which can create the impression of stability and control. Photo by Getty ImagesI have been watching a familiar pattern unfold over the past few years, with retail investors steadily moving into a segment of the market that appears to be in the early stages of a correction.Subscribe now to read the latest news in your city and across Canada.Exclusive articles from Barbara Shecter, Joe O'Connor, Gabriel Friedman, and others.Daily content from Financial Times, the world's leading global business publication.Unlimited online access to read articles from Financial Post, National Post and 15 news sites across Canada with one account.National Post ePaper, an electronic replica of the print edition to view on any device, share and comment on.Daily puzzles, including the New York Times Crossword.Subscribe now to read the latest news in your city and across Canada.Exclusive articles from Barbara Shecter, Joe O'Connor, Gabriel Friedman and others.Daily content from Financial Times, the world's leading global business publication.Unlimited online access to read articles from Financial Post, National Post and 15 news sites across Canada with one account.National Post ePaper, an electronic replica of the print edition to view on any device, share and comment on.Daily puzzles, including the New York Times Crossword.Create an account or sign in to continue with your reading experience.Access articles from across Canada with one account.Share your thoughts and join the conversation in the comments.Enjoy additional articles per month.Get email updates from your favourite authors.Create an account or sign in to continue with your reading experience.Access articles from across Canada with one accountShare your thoughts and join the conversation in the commentsEnjoy additional articles per monthGet email updates from your favourite authorsSign In or Create an AccountorBefore I talk about that segment, it reminds me about a different type of risky investment I wrote about years ago, drawing on lessons from my time as a research analyst when I noticed that underwater bought deal equity offerings were being handed off, along with the associated commissions, from capital markets desks to investment advisers and then repackaged and marketed to clients as a so-called “hot deal.”The intent is to signal exclusivity and sophistication by offering access to strategies that were once the domain of pensions and endowments. While that type of access can appear attractive to retail investors, and in some cases genuinely useful to individual investors, it rarely comes without some cost. At some point it becomes a matter of applying some basic common sense, because one has to ask why an opportunity would be sliced into thousands of small allocations for individuals rather than placed in a single transaction with a large institution that has the scale, resources, and bargaining power to absorb it entirely. That kind of buyer typically negotiates better terms, lower fees and stronger protections.Canada's best source for investing news, analysis and insight.By signing up you consent to receive the above newsletter from Postmedia Network Inc.A welcome email is on its way. If you don't see it, please check your junk folder.The next issue of Investor will soon be in your inbox.We encountered an issue signing you up. Please try againNow for the segment in question. For much of the past decade private equity and private credit were built and sold in a world defined by falling rates, abundant liquidity and a persistent search for yield, which encouraged investors to move further out on the risk spectrum in exchange for incremental return. As rates compressed and traditional fixed income offered little in the way of income, private credit in particular emerged as an attractive alternative, while private equity benefited from cheap financing, rising multiples and an environment that allowed time and leverage to do much of the work.Now that rates have moved off their lows and the cost of capital has reset higher, these strategies are increasingly being brought to a broader audience in search of incremental demand, arriving at a point in the cycle where the assumptions that supported their past success are beginning to be tested.Part of the appeal of private investments lies in what is not seen, because without continuous market pricing the volatility appears muted and the return profile looks smoother, which can create the impression of stability and control. In truth, this is often just the absence of price discovery, where transactions that would otherwise reveal changing valuations are simply not occurring or not observable, rather than the absence of risk.For example, if you were to price your home every day, you would likely experience the same swings that investors endure in public markets, but because that does not happen you rely on occasional appraisals and only discover its true value when you go to sell. The underlying economics of the asset do not change simply because they are not being constantly observed.The businesses held within private structures are no different from their public counterparts in that they are still subject to margin pressure, refinancing risk, competitive threats and economic cycles, and defaults still occur even if they are less visible along the way. What changes during periods of stress is not only the eventual outcome of the investment but also the investor’s ability to respond in real time, as liquidity, flexibility and behaviour move from being secondary considerations to the primary drivers of experience. And it is precisely here where private market structures tend to impose the greatest constraints at the exact moment they matter most.The issue is not that private markets are inherently flawed or unworthy of consideration, but rather that their design can amplify problems for individual investors if approached without discipline, since illiquidity, limited transparency and incentive structures tend to favour larger investors with incredibly long-time horizons. Institutional and family office portfolios are built around a very different set of conditions. These include effectively permanent capital, predictable inflows, long governance cycles and, most importantly, the ability to remain invested through difficult periods without being forced into action, which is a constraint most families simply cannot replicate.Fast forward to today and we are now beginning to see some of these risks materialize particularly within private credit, where rapid growth has brought the asset class to a scale that is now being tested by tightening financial conditions and rising borrower stress.The conclusion is not that private investments should be avoided altogether, because they can play a useful role in portfolio diversification by providing exposure to areas of the economy that are not publicly listed and by offering differentiated sources of return. The mistake is in treating them as a straightforward upgrade to traditional portfolios rather than as distinct instruments with their own advantages, limitations and behavioural implications, which require a different mindset and a higher tolerance for uncertainty around timing and liquidity.In practice, the real question is more of sizing and suitability rather than access, as a high-net-worth investor with stable cash flow, a long time horizon and a clear understanding of how these structures behave under stress may choose to allocate a modest portion of capital to them. For most individuals, this points to a range that is measured often in the area of five to 10 per cent, and even then, it requires that you are being compensated appropriately for the illiquidity risk you are taking on.And if you are being sold anything that simply looks too good to be true, remember that old poker saying that if you sit down at the table and cannot identify the mark, it is probably you. That’s a hot deal that you may just want to pass on.Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc., operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning. The opinions expressed are not necessarily those of Wellington-Altus._____________________________________________________________If you like this story, sign up for the FP Investor Newsletter. Join the Conversation This website uses cookies to personalize your content (including ads), and allows us to analyze our traffic. Read more about cookies here. By continuing to use our site, you agree to our Terms of Use and Privacy Policy.