The Liquidity Trap: Why Private Market Access Often Costs More Than It Is Worth

In the push to make private markets accessible to more investors, many are trading liquidity for theoretical premiums that rarely materialize. Brian Moriarty and Jack Shannon of Morningstar point out that semi-liquid vehicles like interval funds, tender offer funds, and non-traded BDCs often hide operational risks and fee structures that eat into investor returns. This creates a liquidity mismatch where managers, who are used to long-term lockups, struggle to handle the periodic redemption windows promised to retail investors. For financial advisors and sophisticated investors, the real advantage is not in the access narrative, but in the forensic analysis of fee transparency and operational infrastructure. Those who wait for evidence of full-cycle durability instead of chasing private market exposure will avoid the structural traps currently sold as innovation.

The Illusion of the Illiquidity Premium

The industry suggests that investors earn a premium for locking up capital. However, Moriarty and Shannon argue that this premium is often an accounting artifact rather than a genuine return. In many cases, the excess return over public markets comes entirely from leverage. When managers use leverage to boost returns, they do not just amplify the upside; they create a fragility that can lead to a death spiral when investors demand their liquidity.

The issue with leverage is not the upside, it is the downside. When you have a couple of down days, the leverage exacerbates that terribly and then investors want to pull their money and it creates this spiral, this death spiral of a fund.

-- Brian Moriarty

Because these funds offer periodic liquidity, they must hold liquid assets like cash or syndicated loans to meet redemptions. This creates a drag on performance. Managers are caught between the need to hold liquid, lower-yielding assets and the pressure to deliver the high returns that attracted investors. This tension creates a feedback loop: the most successful funds attract the most capital, but if they lack the infrastructure to manage outflows, they become the most vulnerable to forced liquidations.

Valuation Gaming and the Phantom Return

A central risk in private markets is the lack of transparent, market-based pricing. Unlike public equities, which react instantly to market sentiment, private valuations are often marked by the managers themselves. This creates an incentive to keep valuations artificially high to support fee generation and avoid the volatility that would scare off retail investors.

If you look at some of these unlisted BDCs, some of them will not include the incentive fee in their prospectus fee table... they are being very coy there, they are going to collect this fee pretty much every time.

-- Jack Shannon

The consequence of this valuation opacity is the creation of phantom returns. When a fund buys secondary interests in private equity at a discount to NAV and marks them up to the full NAV, it creates a one-day gain that is purely an accounting maneuver. This is not a cash-flow-driven return, yet it appears as performance on a fact sheet. The system rewards managers who keep valuations smooth, effectively penalizing those who are more intellectually honest about market reality.

The Two-Wolf Culture Problem

Moriarty introduces a two-wolf framework for evaluating these firms: the Deal Team, focused on sourcing the next investment, and the Investment Team, focused on managing the portfolio and liquidity. In many firms, the Deal Team is the hungrier wolf, dominating the culture and internal politics.

When the Deal Team dictates firm culture, the focus remains on acquisition rather than long-term stewardship. This creates a downstream risk: the firm may lack the robust risk management and trading infrastructure required to handle the complexities of a semi-liquid wrapper. Investors who fail to distinguish between firms that prioritize deal-making and those that prioritize operational maintenance are effectively betting on a firm that may not be equipped to handle the first real cycle of sustained outflows.

Key Action Items

• Standardize Fee Analysis: Stop relying on prospectus fee tables. Demand or calculate the Total Cost of Ownership by flowing a uniform 10% gross return assumption through the fund’s specific fee structure, including incentive fees and borrowing costs. (Immediate)
• Audit Realized vs. Unrealized Gains: Review fund filings to see what percentage of performance is paper gain. If the majority of returns are unrealized, discount the performance significantly. (Next 30 days)
• Stress-Test Liquidity Sources: Look past the liquidity waterfall charts in marketing materials. Identify if the listed sources of liquidity are actually just forms of additional leverage, which will fail when you need them most. (Next quarter)
• Evaluate Pick Exposure: For private credit funds, monitor Payment in Kind (PIK) levels. High PIK exposure suggests the fund is masking cash-flow issues by taking interest in the form of more debt. (Ongoing)
• Demand Operational Transparency: Prioritize managers who provide metrics like non-accruals and interest coverage rather than those highlighting standard deviation or Sharpe ratios, which are often misleading in private markets. (12-18 months)
• Seek Eat Your Own Cooking: Favor teams where the managers have significant personal capital invested in the fund, signaling alignment beyond just fee extraction. (Immediate)