As a boutique financial consulting firm that guides hedge funds, family offices, and high-net worth individuals around the world, we often receive questions around the differences between investing in private markets versus public markets and this blog touches a little more on that.

On the surface, the investment in private markets can be classified as those investments made across private equity, private credit, real estate and infrastructure where securities are not traded on a public exchange; rather exchanged over the counter (OTC) through a financial intermediary (e.g. investment bank).

Conversely, the investment in public markets can be classified as those investments made across public equity markets (S&P 500/DJIA etc.), debt markets (corporate/government bonds), commodity futures/derivatives markets and others that are traded on a public exchange (NYSE/Nasdaq/CBOE/CME).

While public markets can often be characterized by much higher levels of liquidity and by a more efficient and competitive means of price discovery, private markets can often be characterized by much lower levels of liquidity and are typically much less efficient in terms of price discovery. And liquidity can be defined as the ease/timeliness in which an investment can be unwound or sold and converted to cash without losing significant value. Market inefficiencies can be characterized as a disconnect between price and value.

To understand this first principle of market function we must consider the 3 assumptions of the Efficient Market Hypothesis:

  1. Equal access of information to all participants
  2. Rational behavior of market participants
  3. Zero transaction costs

Firstly, it is important to understand that private market investments are mostly restricted to institutional investors. Secondly, while institutional investors should be considered professional investors, their behavior and actions especially during periods of extreme market distress and calamity can often be described as irrational. And thirdly, private investments typically have high transaction costs (e.g. investment bank underwriting fees/commissions) that limit the participation to only institutional investors.

For these reasons, it is often possible for investors to capture greater market inefficiencies in the private markets but with a tradeoff of having lower liquidity which is most often compensated for by an illiquidity premium of 3-5% above the historical rate of return in public markets. This illiquidity premium has been established to compensate investors in the private markets for how liquidity can deteriorate rapidly during periods of calamity and market turmoil making it extremely challenging for investors to unwind their positions.

For example, anyone who has ever sold a large commercial real estate property during periods of macroeconomic turmoil understands the pain of selling assets when liquidity is scarce.

If you are an institutional investor or high-net worth individual with questions on how to identify market inefficiencies for securities of various asset classes in the private or public markets, we are here to help you on that journey and only a click/call away.