Private Markets Hide Distress Through Misleading Metrics

The opaque world of private markets, often shrouded in complexity, harbors hidden dynamics that can dramatically alter investment outcomes. This conversation with Leyla Kunimoto, founder of Accredited Investor Insights, peels back layers of conventional understanding to reveal the subtle yet significant consequences of how private credit and private equity are measured, marketed, and managed. Beyond the headline performance figures lie critical considerations about valuation, liquidity, and the very definition of value in markets where transparency is scarce. Investors, particularly those venturing into these less regulated spaces, stand to gain a substantial advantage by understanding these downstream effects, recognizing where standard metrics falter and where true value is obscured by accounting conventions. This analysis is crucial for sophisticated investors and financial advisors seeking to navigate the promise and peril of private markets with a clearer, more discerning eye.

The Illusion of Transparency: How Private Credit Hides Distress

The explosive growth of private credit, fueled by a decade of low interest rates and a flood of capital, has created an environment ripe for overlooked risks. While headlines might point to isolated bankruptcies, Leyla Kunimoto argues that these are not mere anomalies but "canaries in the coal mine," signaling broader issues with underwriting and covenant quality. The very structure of private credit, designed to be less regulated than traditional banking, allows for bespoke loan terms that can obscure a borrower's true financial health.

A key mechanism for this opacity is "Payment-in-Kind" (PIK) interest. Instead of cash, borrowers can tack interest payments onto the loan principal. While this can be a legitimate tool for fast-growing, cash-burning companies, it creates a misleading picture for lenders and investors. A loan accruing PIK interest is considered current by the lender, even if the borrower is struggling to generate actual cash. For investors in private credit funds, this means distributions might be covered by interest that hasn't been paid in cash, masking underlying distress. Kunimoto identifies PIK as "the only reliable signal" for evaluating private credit funds, noting that tracking its increase quarter-over-quarter can reveal a distressed borrower base, even when traditional default metrics remain low. The implication is that the readily available capital in the market incentivizes lenders to overlook or loosen standards, leading to a proliferation of loans that appear healthy on paper but carry significant hidden risk.

"When you have a lot of money and when you need to place that money very quickly, there is an incentive for the lender to maybe overlook or be a little bit looser on covenants or maybe loosen up your underwriting criteria a little bit."

-- Leyla Kunimoto

This dynamic creates a systemic risk, not necessarily mirroring the 2008 crisis due to private capital's separation from the banking system, but certainly presenting a "stretched borrower" scenario. The aggressive marketing of private credit as the "next best thing" to both institutional and retail investors further exacerbates the issue, creating a demand that can outpace prudent lending practices.

The PME Paradox: Why Private Equity Performance Metrics Deceive

In private equity, the pursuit of comparative performance metrics often leads investors down a misleading path. The Public Market Equivalent (PME) metric, intended to measure a private equity fund's outperformance against a public index, suffers from fundamental flaws rooted in the very nature of private market investing. Kunimoto highlights the critical difference in capital deployment timelines. Investors commit capital to a private equity fund, but this capital is typically called over a period of several years. The PME calculation, however, often starts counting the performance from the moment the capital is deployed, not from the investor's initial commitment.

This creates a "drag" because the investor's committed capital sits idle, earning little to no return, between the commitment date and the deployment date. Furthermore, when private equity funds return capital, they do so in chunks as investments are realized, not in one lump sum. This requires investors to then redeploy that capital, again facing a delay before it can generate returns.

"The problem there is with PME, the PME starts counting when that 50,000 was deployed. Okay. For me, for the investor, that's not when I committed the capital, and I'm not going to earn 15% between the day I committed capital and deployed it."

-- Leyla Kunimoto

This timing mismatch means that PME can artificially inflate a fund's relative performance, making it appear superior to public market investments when, in reality, the investor has experienced a longer period of capital inefficiency. The system is designed to favor the fund manager's timeline, not the investor's experience of capital at work. This disconnect is a prime example of how conventional metrics fail to capture the full downstream effects of private market structures.

The Secondary Market Mirage: Gains on Paper, Not in Cash

The burgeoning secondary market in private equity offers a lifeline for institutional investors seeking liquidity, but it also presents a significant valuation challenge, particularly for retail investors. When a secondary fund purchases a stake in a private equity fund from an investor needing cash, they often acquire it at a discount to the Net Asset Value (NAV). For instance, a stake valued at $25 per share might be bought for $15. The practical expedient rule then allows the secondary fund to immediately mark this $15 purchase price back up to the $25 NAV, creating an instant, albeit unrealized, gain.

Kunimoto likens this to buying a car below sticker price but immediately valuing it on your personal balance sheet at the sticker price. This practice inflates reported returns, as these "paper gains" are recognized without any cash being generated. This is particularly problematic because General Partners (GPs) in some funds are compensated based on both realized and unrealized gains. The ability to generate these immediate unrealized gains can attract further inflows, creating a cycle of "rinse and repeat" fundraising.

"The sticker on that car was $52,000. This is exactly what happens here."

-- Leyla Kunimoto

This accounting convention, while perhaps legally permissible, distorts the true economic performance of these funds. The market value, as evidenced by the willingness of a willing buyer and seller to transact at a discount, is ignored in favor of an internally determined NAV. This lack of true market-based valuation means that reported gains in the secondary market can be more a function of accounting rules than genuine value creation, a critical insight for investors lured by seemingly robust performance figures.

Key Action Items

• Immediate Action (0-3 months):

  • Scrutinize private credit fund disclosures for the prevalence of PIK interest. Prioritize funds with lower PIK percentages and clear cash-flow coverage for distributions.
  • When evaluating private equity funds, understand the PME calculation's methodology and its potential timing discrepancies. Look for funds that clearly articulate how capital deployment and return timelines are handled.
  • Request clear, itemized schedules of holdings showing cost basis alongside fair market value, rather than relying on footnote disclosures. Flag funds that obscure this information.

• Short-Term Investment (3-12 months):

  • Develop a framework for assessing private credit risk beyond headline default rates, focusing on underwriting quality, covenant strength, and PIK usage.
  • Seek out private equity funds that provide more granular reporting on capital calls and distributions, allowing for a more accurate assessment of investor capital efficiency.
  • Engage with financial advisors to understand their due diligence process for private market investments, specifically how they address valuation and liquidity challenges.

• Long-Term Investment (12-18+ months):

  • Prioritize investments in private market vehicles that offer greater transparency and more robust liquidity options, even if they come with slightly lower headline returns.
  • Advocate for improved accounting standards and disclosure requirements in private markets, particularly concerning secondary market valuations and the reporting of cost bases.
  • Consider the impact of fund maturity schedules and debt structures on long-term cash flow and refinancing risk when making allocation decisions.
  • Build a diversified portfolio that balances the illiquidity of private markets with the need for accessible capital, carefully considering personal liquidity requirements.