Brian Moriarty and Jack Shannon: Putting Private Markets Funds Through Their Paces

Episode Summary

Executive Summary: The episode explains how private markets are being packaged for advisors and retail investors through semi-liquid vehicles, and why Morningstar is scrutinizing them closely. Brian Moriarty and Jack Shannon argue that liquidity, valuation, leverage, fees, and team quality create major risks that often get obscured by marketing. Their key point: access alone is not enough—investors should expect excess return, clear disclosures, and a manager capable of honoring redemption promises.

Main Topics: What private markets are and why they’re growing (Priority: 5/5): Brian defines private markets as investments outside public exchanges and notes the rapid growth in private equity and private credit since COVID, alongside the push to sell these strategies to wealth channels. Semi-liquid fund structures and the liquidity challenge (Priority: 5/5): Jack explains interval funds, tender offer funds, unlisted BDCs/REITs, and other vehicles that offer periodic rather than daily liquidity. The discussion centers on whether these structures can deliver what they promise in stressed markets. Morningstar’s due diligence framework: process, people, parent, price (Priority: 5/5): The guests map Morningstar’s traditional manager-research framework onto private assets, emphasizing that the same four Ps still matter but need to be interpreted differently because private markets are less transparent and less liquid. Liquidity, redemptions, and leverage trade-offs (Priority: 5/5): A major theme is that managers often carry more liquid assets or use leverage to meet redemptions, both of which can depress returns or amplify losses. The guests warn that many firms have oversold liquidity. Valuation opacity and ‘phantom returns’ (Priority: 4/5): Jack highlights how infrequent marking and different valuation methodologies can create returns that look strong on paper but may not be realized, especially in private equity and venture funds. Fee complexity and true all-in cost (Priority: 4/5): Jack argues these products are expensive and often use layered fees, incentive fees, borrowing costs, and selective disclosure. Morningstar is working on standardized fee methodology to compare products on an apples-to-apples basis. What the Medalist rating is meant to signal (Priority: 5/5): Brian explains that Morningstar’s Medalist ratings aim to identify semi-liquid funds likely to outperform public-market equivalents after accounting for liquidity sacrificed, fees paid, and manager/structure quality.

Key Arguments: Private markets are defined by lower transparency and harder-to-access data than public markets, which makes due diligence more difficult. Semi-liquid funds are gaining traction because they package private assets in familiar wrappers, but the liquidity they advertise may be overstated. Liquidity is the central underwriting issue: managers must match redemption terms with the liquidity of underlying assets, or risk failure like a fund conversion or redemption strain. Managers often must hold more liquid assets to meet redemptions, which can reduce returns; the least liquid portfolios often offer the highest returns and therefore attract the most capital. In many private credit products, leverage may account for much or all of the excess return versus public-market alternatives. Leverage can improve returns in stable periods, but it magnifies downside and can create a spiral when outflows and falling prices coincide. Private equity and venture valuations are inherently less frequent and more subjective, which can lead to unrealized gains that resemble paper profits more than actual cash returns. Morningstar looks for valuation methods that are consistent and grounded in market reality, even if different approaches are used across firms. Private credit analysis should include net interest coverage, PIK exposure, non-accruals, and other credit-quality indicators rather than relying on volatility metrics. Traditional public-market risk measures like standard deviation and Sharpe ratio can be misleading in private markets because subdued marks suppress volatility. Team stability, personal investment in the fund, and intellectual honesty about risk and liquidity are important indicators of manager quality. Fees in semi-liquid funds are materially higher than in mutual funds and ETFs, and true all-in costs must include incentive fees and borrowing costs. Morningstar’s Medalist rating is intended to signal whether a private-market fund has enough expected advantage to justify the liquidity sacrificed by the investor.

Data Points: Private market definition: Anything outside public markets - Brian’s definition of private equity and private credit during the opening segment. Growth period: Roughly since COVID - Brian says the private markets have grown astronomically in the last couple of years, especially since COVID. Liquidity terms: Quarterly, monthly, semi-annually - Jack describes typical periodic redemption windows for semi-liquid funds. Investor exit pressure: 12–15%, 20%, 30% - Brian and Jack cite examples of redemption/outflow levels in public funds and private vehicles; Jack notes some funds can see 12–15% NAV returned yearly, while Brian references 15–20–30% outflows in public funds. Typical private equity distributions: 12% to 15% of NAV returned every year - Jack cites historical private equity fund distributions when discussing liquidity gaps. Public fund outflows: 15%, 20%, 30% - Brian says many public mutual funds and ETFs have experienced extreme annual outflows at or above private semi-liquid fund liquidity levels. Unlisted BDC leverage: Can exceed interval fund leverage - Brian explains that unlisted BDCs can use more leverage than interval funds, which face statutory leverage limits similar to listed closed-end funds. Standard deviation relevance: Much less useful in private markets - Brian argues public-market volatility metrics are not very informative for private portfolios with muted marks. Fund age: Most are very young - Brian notes the limited data history on semi-liquid equity funds makes rating them harder. Incentive fee structure: Often effectively a doubled management fee - Jack says incentive fees plus management fees can behave like two management fees in practice. Good PIK example: 3 years - Brian describes a data-center financing loan that may use payment-in-kind for the first three years until cash flow begins.

Pivotal Quotes: "Access should not be the end of this, right? The investor is giving up liquidity in their own portfolio when they are investing in one of these products. And so they should expect some return, some excess return, in exchange for giving up that liquidity." — Brian Moriarty: On why private-market access alone is not a sufficient selling point. "If you're a manager of this fund, how much of the fund do you personally own, right? We want to see that you believe in yourself and your own team." — Jack Shannon: On the ‘people’ due-diligence factor and manager alignment. "The issue with leverage is not the upside, it's the downside." — Brian Moriarty: On why leverage can boost returns but creates severe risk during drawdowns and redemption pressure.

Implications: Investors should treat private-market access as a trade-off, not a free upgrade. The real test is whether a manager can deliver excess return after fees, leverage, and liquidity constraints. Expect tighter scrutiny of redemption terms, valuations, and total costs.