A practical field guide for RIAs evaluating a custom private fund strategy.
In public markets, the experience is simple by design. You can implement an allocation quickly, see performance cleanly, and move money with minimal friction.
Private markets are not built that way. Whether you’re a novice or experienced in launching private market vehicles, the opaqueness remains either a barrier to entry or an impediment to scale. Advisors underscore this: more than two-thirds cite the inherent complexity of private markets as a key challenge in client discussions, especially around mechanics like pacing, liquidity, and performance reporting.
That complexity is not what draws RIAs to private funds in the first place. It is simply part of the terrain. The question is less whether complexity exists, and more whether it is understood and planned for ahead of time.
A “custom fund,” as we define it, is a closed-end drawdown vehicle containing private funds or individual investments designed to give dozens of underlying investors easy access to private market exposure into a single, firm-aligned allocation. One that reflects your philosophy, your manager preferences, and the client experience you want to deliver. Instead of asking clients to evaluate and subscribe to a new private fund every time an opportunity appears, a custom fund creates a repeatable structure you can build on over time.
These vehicles are not new. They have been around for decades and have long been part of how institutions and many sophisticated RIAs allocate to private markets. They may not be the most talked about structure today, with evergreen funds capturing much of the attention, but there is a reason closed-end drawdown vehicles continue to represent a meaningful share of private market allocations. When implemented well, they have historically delivered strong outcomes and allowed wealth managers to access the best private managers.
At the same time, custom funds still feel like a big step, especially in the wealth channel. And that hesitation is rational.
When I speak with advisors who are considering this path, the concerns tend to be consistent:
This field guide exists for one reason. To make the requirements, tradeoffs, and ongoing expectations visible before you commit, so you can avoid common pitfalls, learn from peers who’ve been through it, and approach a custom fund with a clearer plan and fewer surprises.
How to use this guide
This is not a checklist you need to complete before moving forward. In practice, very few RIAs hit all of these signals at launch, and many successful custom funds were built while firms were still working through one or more of them.
Instead, think of this as a maturity map. These signals reflect where firms tend to arrive over time as they gain conviction, experience, and infrastructure. Some will resonate immediately. Others may feel aspirational. That’s expected.
The goal of this field guide is not to tell you whether you’re “ready” or not. It’s to help you understand what becomes important, when, and what tradeoffs you’re implicitly making at each stage.
Before thinking about structure, vendors, or managers, most firms find it helpful to get clear internally on one foundational question. How much illiquidity clients can bear and want to bear. That decision influences pacing, client segmentation, and which private strategies make sense, whether venture, credit, real estate, or a mix.
Why it matters: This is not just an allocation question. It is strategy-defining. In practice, RIA firms that have not aligned on illiquidity often find themselves revisiting core decisions later in the process, debating whether venture belongs in the mix, how much cash flow matters, or how patient clients truly are.
What we see in practice: Firms that handle this well are not guessing. They have had explicit internal conversations about how different client segments experience illiquidity, and they accept that not every private strategy fits every client, even within a custom fund.
What it affects downstream: Illiquidity assumptions shape portfolio construction, capital call pacing, and client communication.
Signal of progress: You can articulate a target private allocation range for the right clients and explain why.
Closed-end drawdown funds do not behave like public market allocations. Capital is called over time. Distributions arrive unevenly. Early performance can look unintuitive. It is not bad. It is simply different.
Why it matters: If you’re not managing the liquidity operations around the purchase of sale of private companies, the fund you’re investing in is. Avoiding dealing with them purely for the sake of convenience usually means they show up in the form of lower returns down the road.
What we see in practice: Clients rarely ask for drawdown funds explicitly. They care about results. Advisors who struggle here are often trying to make private markets feel like public markets, rather than setting expectations for how private investments actually work.
What it affects downstream: Client education, performance conversations, and confidence during early quarters when capital has been called but results are not yet visible.
Signal of progress: You’re aligned on the results you’re trying to achieve for clients and comfortable setting client expectations for their experience with private markets.
A custom fund only works if the client base supports it. In most cases, that means meaningful accredited investor density and, ideally, a material base of qualified purchasers. Your ability to access differentiated opportunities is partially a function of size, and banding your clients together can offer each of them a better deal than going it alone.
Why it matters: Eligibility is not just a legal box to check. It determines whether the vehicle can be diversified properly and whether capital can be deployed at the intended pace.
What we see in practice: RIA firms that underestimate this often rely too heavily on a small number of clients to make the math work, which introduces fragility if even one large investor chooses not to participate.
What it affects downstream: Portfolio construction, concentration risk, deployment timing, and the long-term viability of the vehicle.
Signal of progress: You know the percentage of clients eligible to participate and have evaluated the client portfolio implications to reach your target fund size.
Across the custom fund launches I have been involved in, investment leadership not being aligned on whether private funds can produce above market returns is perhaps the largest impediment. This challenge does not always show up as open conflict.
Why it matters: Misalignment does not fail loudly. It fails quietly. Capital raises underperform expectations, conviction weakens, and timelines stretch.
What we see in practice: Instead of refining strategy and communicating clearly with clients, firms spend energy internally debating whether the approach is right at all.
What it affects downstream: Fundraising success, advisor confidence in client conversations, and speed to steady state.
Signal of progress: There is consensus on the why and the how with key stakeholders identified and engaged to support execution.
Multi-manager custom funds often feel hardest at launch because the work is front-loaded. Identity documents, accreditation verification, client education, and onboarding all happen at once.
Why it matters: The upfront effort is what creates leverage later. Without it, firms often end up repeating the same work fund after fund.
What we see in practice: Launch quarter friction is frequently misinterpreted as a structural flaw, often accompanied by a flurry of emails, calls, and internal questions, when it is actually the cost of building a repeatable system.
What it affects downstream: Operational drag, tax complexity, advisor time, and the ability to scale commitments with ease over time.
Signal of progress: You are willing to invest effort upfront to gain long-term efficiencies.
Most firms we work with don’t hit all of these signals before they begin, and still launch custom funds successfully. Yet, even when the signals are there, some firms still hesitate. Usually, because they have seen or heard about custom fund launches that went sideways.
In practice, the most common failure points when launching a custom fund are not investment ideas. They are tied to execution.
The patterns that show up most often:
How firms de-risk these issues in practice:
Even if you don’t check every box today, reading through these risks and patterns gives you insight from peers who have already been through it—context many firms don’t have going in. You don’t have to start perfect to start informed.
Private markets will always be more complex than public markets. Yet, if the goals and strategy are aligned with your firm’s ethos for both the near term and long-term, navigating to the “how” becomes manageable. More than that, it becomes an org-wide action plan.
When the responsibilities are clearly understood, and the right infrastructure is in place, a custom fund becomes a practical way to deliver differentiated exposure, scale your process, and create a client experience that feels institutional.
This is what it means to set a new standard.
Gridline is a turnkey alternatives management platform built to set a new standard for private market investing. We work with RIAs to make private markets as easy to operate as trading stock, without sacrificing rigor or control.
Through our Custom Funds, Gridline helps RIAs launch and manage closed-end drawdown funds by providing a single platform for fund formation support, subscriptions, capital calls, performance reporting, and ongoing operations. The goal is simple. Absorb the operational complexity so advisors can focus on investment decisions and client relationships.
For a closer look at how Gridline supports RIAs launching closed-end drawdown vehicles, you can view our Custom Funds one-pager here.
Charles Patton leads manager selection, portfolio construction, and General Partner (GP) relationships at Gridline as Investment Director. Prior to joining Gridline in November 2022, Charles worked on Wells Fargo’s Investment Portfolio team and previously served as a Summer Associate at the University of Virginia Investment Management Company (UVIMCO). While earning his MBA at the University of Virginia’s Darden School of Business, he was Chief Investment Officer of Darden Capital Management. Charles holds an undergraduate degree from the University of North Carolina and is a CFA charterholder.
The allure of private equity lies in its potential for superior returns, which hasn’t escaped individual investors’ notice. Over the past quarter-century, private equity has yielded an impressive 14% return globally, doubling the 7% offered by the MSCI World Index.
Nevertheless, in contrast to public markets, success in private markets is far from a given, owing to the challenge of picking the right investments and the relative scarcity of data.
Mechanism design is employed to safeguard returns on private investments, including but not limited to governance, project finance, return protection, and meticulous control mechanisms.
Mechanism design, often hailed as ‘reverse game theory,’ has its roots firmly planted in the arena of economic theory. Championed by Leonid Hurwicz, the 2007 Nobel Laureate in Economics, it revolves around creating a strategic environment or ‘game’ that induces participants to behave in a way that leads to a desired outcome.
Hurwicz and his collaborators, Eric Maskin and Roger Myerson, also Nobel Laureates, made significant contributions to developing and applying this theory. Their work has provided a theoretical basis for understanding how private markets function.
As per Hurwicz’s theory, mechanism design attempts to construct systems that provide the right incentives to encourage the most beneficial behavior from each participant. It’s like designing a game where the rules are laid out so that the players, acting in their own self-interest, will bring about an optimal outcome for everyone involved.
In private markets, the mechanism design theory finds significant application. Consider private equity, for example, where the relationship between general partners (GPs) and limited partners (LPs) is a prime case of a ‘game.’ The GPs, who manage the investments, and the LPs, who provide the capital, have incentives and information. The mechanisms used, such as carried interest and hurdle rates, align the interests of the GPs and LPs, leading to mutually beneficial outcomes.
Fortunately, private market conventions have evolved to align interests. For example, fees over the first several years of an investment partnership are commonly calculated on committed capital rather than invested capital, reducing the incentive for GPs to quickly invest in substandard deals to start receiving fee income. Similarly, carried interest (commonly called carry) often represents 20% of the proceeds from any investment sale, but that is frequently only available to GPs if the investment being sold has compounded in value above 8% annually. This ensures that GPs are not being rewarded for holding a mediocre investment for several years, nor are they receiving carry based on their own estimates of portfolio value.
A deep dive into the performance of private markets over the past two decades unveils a consistent trend of outperformance compared to their public counterparts. The Hamilton Lane 2022 market overview report provides compelling evidence of this. It reveals that every year in the past twenty, buyout returns in private markets have surpassed the MSCI World PME by a staggering average of 1,000 basis points.
Similarly, private credit has not lagged, having consistently exceeded the performance of leveraged loans annually by an impressive 625 basis points over the same period. This long-standing trend demonstrates the potential for superior returns in the private market sector.
During 2022, private markets displayed remarkable resilience, surpassing public strategies across all sectors. Illustratively, buyout returns in private markets outpaced the S&P 500 by almost 2,050 basis points. Furthermore, the private sector’s infrastructure and real estate exceeded the FTSE All Equity REITs Index by a considerable margin, over 3,400 basis points, to be precise.
A 2023 survey showed that 86% of participants believe that the trend of private markets outperforming public markets is likely to continue. This sentiment points to the growing confidence in private markets and their potential for higher returns.
Moreover, historical data indicates that private equity provides superior risk-adjusted returns and tends to outperform public equity by a more significant margin, especially during periods of economic distress. This pattern suggests that the mechanisms at play within private markets can effectively contribute to higher returns.
With Gridline, private market investing becomes more straightforward and more accessible. We provide the tools to navigate these markets effectively, harnessing the power of diversified, professionally managed funds.
Investors and their advisors typically apply a set of common sense principles to craft a balanced public market portfolio that performs over the long term. Several of these same principles are essential when investing in private markets and can be applied when investing through Gridline.
Trying to beat the market tends not to work. This is why savvy investors typically do not just buy Apple and Microsoft when they could own the entire Nasdaq.
Historically, most people who say “I’m in alts” are participating in a couple of funds but don’t have a private market portfolio built on proven principles.
Rather than trying to hit a home run with one or two funds, Gridline’s thematic portfolios allow investors to spread capital amongst multiple managers, multiple underlying sectors, more geographies, and more vintages.
Even if the portfolio were to simply track the private equity market and deliver a median return, for example, an investment in this type of product still boosts the blended average return of an investor’s entire portfolio. Layer on a very large sourcing funnel and rigorous due diligence, and the portfolio’s total results have the opportunity to outperform industry benchmarks.
The core-satellite approach deployed by Gridline has been utilized in the public space for decades. Investors have beta generators, often at least 40-50% of their public market portfolios, which track the asset class, and potential alpha generators, which can deliver superior returns.
Just as in public markets, in private markets, academic research supports the addition of emerging private market fund managers and their ability to generate significant alpha.
In public markets, investors often make regularly timed purchases in the asset class to smooth out volatility rather than throwing in a lump sum.
The same applies to the private markets. For example, if investors want PE exposure, they can participate in our Buyout Portfolio in the 2024 vintage, 2025, and 2026 to get steady exposure to the asset class throughout changing economic conditions.
By introducing index-based investing, Vanguard became one of the largest and most influential forces in the asset management industry. It offered investors a low-cost way to instantly buy a diversified segment of the public markets.
Gridline provides this same ability within the private markets. Gridline’s thematic portfolio funds are multi-fund products designed to provide diversified exposure to a particular asset class or strategy with a single investment and low fees.
Funds are carefully selected to include complementary strategies capable of mitigating risk and enhancing return expectations, ultimately providing investors with high-quality, low-cost private market diversification.
When IBM chairman Thomas Watson was selected to serve as ambassador to the USSR in 1979, he had a problem. Ethics norms of the time dictated he needed to dispose of his personal stakes in several VC funds he’d accumulated over years of investing in the early computing industry. Watson tapped Dayton Carr to help market the fund interests. After significant effort, Carr was able to find willing buyers in the nascent private markets ecosystem to complete the sales. This convinced Carr to set up the world’s first dedicated secondaries firm, Venture Capital Fund of America, to pursue the strategy full-time.1 Carr ended up nurturing several industry luminaries, including Jeremy Coller (CEO of Coller Capital) and Andrew Isnard (CEO of Arcis Group).
Today, the industry Carr helped birth transacted $112B of volume in 2023 and has spread into every private asset class.2 Whether because of competitive returns, diversification, or quicker cash conversion cycles, secondaries have become an increasingly important arrow in the quiver of private market allocations available to investors. This article will walk through two common types of secondaries deals, recent trends in different corners of the market, and things for investors to keep in mind before jumping in.
Watson’s quandary is an example of the original form of secondaries transactions, LP stake sales. These involve Limited Partners (LPs) looking to sell private fund interests and secondaries managers hoping to acquire them for less than their intrinsic value. LPs might be looking to sell because of shifting strategic mandates, idiosyncratic personal factors, loss of conviction in a manager’s strategy, or to free up liquidity. Buyers are tempted by typical discounts to Net Asset Value (NAV) at purchase, a shorter runway to liquidity as typical sales take place in the latter years of a fund’s life, and a mostly known and well-diversified portfolio.
Many private fund contracts require General Partner (GP) consent before interests are transferred, which means the GP must approve LP stake purchasers before any sale. This is especially true for Venture managers, who can be sensitive about allowing new investors into the partnership who might publicize portfolio company information. These dynamics help existing LPs in a fund get a leg up when purchasing stakes, as they can be trusted not to circulate information and are knowledgeable enough about the portfolios to ascertain their true value. Because that pool of LPs is often smaller than buyout funds, bidding for venture portfolios tends to be less competitive.
As secondary markets developed, a pattern of LPs looking to unload interests in long-dated funds emerged. Because fund interests might be a bit small by that stage of a fund’s life, LPs might not get great asset pricing. GPs became aware of this dynamic and introduced continuation funds, where LPs would be given the option to sell their interests in one large block and hopefully fetch a better price. GPs are quite enthusiastic about the prospect as it allows them to reap significant carry when LPs extinguish their fund interests and restart the clock on fee income (which GPs receive from new purchasers in exchange for continued management of the assets). Less cynically, they can also allow GPs to pursue more long-term value enhancement plans rather than forcing assets to market prematurely.
From a purchaser’s perspective, continuation vehicles offer the chance to purchase significant exposure to a concentrated portfolio. Because managers typically run a bidding process for the right to participate, secondaries purchasers can get an opportunity to learn more about the assets they’re purchasing, particularly if they are less familiar with the manager. In the words of one market participant, “Managers can sell these assets to any number of people.”3 This same broadly marketed process usually means more competitive pricing, requiring purchasers to be spot on when forecasting portfolio company growth.
Whether on the LP or GP side, this market environment has been conducive to significant secondaries volume. Jefferies estimates that 2023 was secondaries’ second-largest year behind 2021, with volume fairly evenly split between GP continuation vehicles and LP stake sales.2 LP volume was dominated by Pensions and Sovereign Wealth Funds, which is perhaps unsurprising as they are the largest individual pools of capital. On the GP side, higher rates made the traditional exit routes of IPOs, M&A, and dividend recaps scarce, creating a strong opportunity for continuation funds to provide liquidity. Continuation funds reached an all-time high of 12% of global sponsor-backed exits, more than double the average for the previous 3 years.2
The thirst for liquidity has had a knock-on effect on pricing. Below, you’ll find a graph of annual pricing on LP deals across asset classes, where eagle-eyed readers will note that every asset class priced below its pre-COVID average in 2023. However, this was far from evenly distributed as buyout deals rebounded to 91% of NAV while venture pricing remained depressed at 68% of NAV. Part of this spread is due to differences in valuation policies, as buyout managers are often slower to write up portfolio companies than VCs, who typically write up portfolio companies every 1-3 years as they raise additional rounds of capital.4 Those external VC rounds are usually a strong anchoring point for venture valuations, which means that venture managers are slower to write down the value of their portfolios in a downturn.
Beyond technical pricing differences is a supply and demand mismatch. Jeffries pegs the dedicated capital available to pursue secondaries at an all-time high of $255B or 2.3x the market’s volume.2 Most of this dry powder has been raised to pursue buyout opportunities, including $23B for Lexington Partners’ latest fund5 and $25B for Blackstone’s most recent vintage.6 By contrast, the closed nature of many venture secondaries opportunities, smaller opportunity sets, and the higher bar on the diligence of rapidly changing venture-backed companies makes it more difficult to deploy capital at scale. This shows up in the fundraising figures, with the largest secondaries fundraises dedicated to venture Industry’s recent $1.7B vintage7 or StepStone’s $2.6B 2021 close.8
Finally, investors should consider how private secondaries compare with public markets. In the past year, the S&P 500 is up 28%, and the NASDAQ-100 is up 50%.9 Cambridge Associates’ most recent one-year buyout performance was pegged at 6.4%, while venture turned in a -10.4% return.10 So while private company valuations might have looked stretched relative to their public peers in 2023, the growth of public comps mainly fueled by multiple expansion makes the concern less salient in 2024.11
There is strong evidence that more niche secondaries managers engaging in less competitive bidding processes can produce outsized returns. Phil Huber at Cliffwater recently put out a note that segments the secondaries landscape into generalist firms with larger fund sizes and broader remits and specialist firms focusing on a narrower slice of the market.12 He found that Specialists outperformed by ~5% per year across a 250 fund dataset. This makes sense, as we would expect excess returns to be eroded in markets with more dry powder outstanding.
Bringing it all together, investors can benefit significantly from secondaries funds due to a faster payback period than primary investments, increased diversification, and competitive returns. Now is a particularly advantageous time to tap the secondaries markets with discounts to NAV above pre-COVID averages across asset classes and even further above average in more niche spaces like venture. Higher prices for public stocks make these entry points more valuable on a relative basis. When considering how to play the space, investors should consider the degree to which specialization gives a manager they are considering partnering with a relative advantage.
Similar to how a buyout manager would provide capital and expertise to a portfolio company in exchange for equity in the business, GP Stakes investors provide capital and expertise to General Partners (GPs) in exchange for a minority stake in the underlying management company and its GP entities (their funds). The GP Stakes Investor receives a share of future cash flow from net management fee revenue and profits, incentive fees, GP co-investments, and balance sheet realizations. GPs use the capital to help grow the firm by meeting co-investment requirements for upcoming funds, succession planning, or developing new strategies.
There are some unique aspects to GP Stakes investing that set it apart from other private equity strategies:
Ultimately, the investors in this strategy are rewarded when GPs and their funds perform well – raising larger funds, returning to market sooner, achieving better results, and charging higher fees. If you want to learn more about the ins and outs of GP Stakes investing, read our blog post on the topic.
Gridline enables you to invest with top-tier fund managers across private credit, venture capital, private equity, and real assets. Book a time to speak with a member of our team to learn more, or sign up in minutes by clicking the button below to gain access to the platform.
In 1969, a team of researchers at UCLA sent the first message between two computers to Stanford on the Advanced Research Projects Agency Network (ARPANET). Often known as the forerunner of the internet, ARPANET was funded by the Department of Defense to link research institutions with government grants to speed technological development. It only took a few years for one of the academics, Bob Thomas, to create a program named Creeper that could track network activity and report back its findings. This was quickly followed by Ray Tomlinson’s Reaper antivirus software, which chased and deleted Creeper wherever it was found.
This tit-for-tat between Bob and Ray is the first example of cybersecurity in action, and for the past five decades, the battle between those looking to penetrate online networks and those erecting defenses has continued to escalate. In 2023, end-user spending in the market for information security from cyber attacks was projected to reach $188B, which would represent 11.3% growth from 2022. Estimates for how large this market can get vary widely, but a study by McKinsey pegged the top end at $2 trillion.
Why does such explosive growth appear likely? One way to approach that question is to consider how much cybercrime costs today and how that’s likely to change. The team at Cybersecurity Ventures estimated that cybercrime would cost $8 trillion in 2023 and $10 trillion by 2025 due to a host of costs, including data destruction, stolen money, IP theft, and reputational harm, among others. Another barometer includes surveys of top executives purchasing cyber defenses as they are the ones writing the checks. Morgan Stanley asked 100 Chief Information Officers in early 2023 about which programs would receive the largest spending increase, and Security Software came first.1 More revealingly, when asked which programs are most likely to be cut, none of the CIOs mentioned Security Software.
Not only is explosive growth possible, but there are reasons to believe startups will have an outsized role to play in defending against the next generation of attackers. One is that entrepreneurs can structure their firms to prevent today’s threats. Cyber professionals have already started to see Generative Artificial Intelligence (AI) contribute to cyber attacks by making it cheaper for groups to run spear phishing or automated customer support scams. The US government has noticed, setting up an AI Security Center within the National Security Agency (NSA) to guard sensitive information that can’t always be addressed with third-party software. Similarly, advances in quantum computing threaten to make many current encryption methods obsolete. Companies built to stop these new vectors of attack stand to benefit if they can outperform legacy players, and historically, incumbents have struggled to innovate on new products while staying at the cutting edge of their existing products. This is especially easy because experienced cyber operators can offer consulting services independently to generate revenue while developing the next software program to productize their insights.
Considering the size and growth of the cyber market, you might expect the venture industry to be rushing headlong into cyber. TechCrunch’s data disagrees, and they estimate Security startups only raised $2.7B in funding over the first quarter of 2023, down 58% year over year. Beyond a general funding malaise, VCs also might be reacting to the difficulties in investing in the space as a generalist. Cyber-specific VCs enjoy advantages on the sourcing side because their relationships with executives purchasing cyber solutions can help startups get a foot in the door with potentially huge clients. They are also advantaged with investment diligence because extensive experience allows them to more easily separate overhyped players from true security breakthroughs. This is crucially important in an industry where companies can grow revenue before the flaws in their security solutions manifest.
Cybersecurity is an industry ripe for continued growth and disruptive innovation. As investors consider how they want to position portfolios against potential disruptions from AI or quantum computing, it would be wise to consider how cybersecurity investments could function as an (imperfect) hedge. We are excited to see how the space develops in the years ahead and hope that those building protective walls outpace bad actors seeking to scale them.
Liquidity is the ability to convert an asset into cash quickly and without a substantial discount. In other words, it’s how easy it is to sell an asset. Stock markets like the New York Stock Exchange are considered highly liquid because the shares of most publicly traded companies can be bought or sold rapidly and at close to their true value.
With hundreds of billions of dollars in daily trading volume, NYSE’s buyers and sellers can be sure to find each other and complete transactions quickly. Private markets, on the other hand, are much less liquid.
Private market investments often come with a “lock-up” period, meaning that investors are unable to sell their shares for a certain amount of time. While venture funds can have a hold period of up to ten years, disbursements can begin as early as year five or six, with VC-backed companies going public on average 5.3 years after securing their first investment.
This lack of liquidity can be frustrating for investors who want to cash out their investments sooner. But it’s important to remember that illiquidity is often the price of admission for higher returns.
The illiquidity premium is the higher return investors expect to earn for an illiquid asset. This risk premium compensates investors for the inconvenience and added risk of being unable to sell their investment quickly if needed.
For example, let’s say you invest $1,000 in a stock that pays a 5 percent annual dividend. After one year, you’ll have earned $50 in dividends, making your investment worth $1,050.
Now, let’s say you invest the same $1,000 in a private company that doesn’t pay dividends but is expected to go public in five years. Suppose the company’s IPO is highly successful, and you sell your shares for $2,000, earning a 100 percent return on your investment.
However, there’s also a chance that the company might not go public or that its shares will be worth less than you paid when it finally lists on an exchange. So, there’s more risk involved in this investment than there was with the stock that paid dividends.
To compensate you for this additional risk, venture capitalists typically expect to earn a higher return on their investments than they would from stocks or other kinds of investments.
Despite the common perception that private markets are illiquid, some recent changes have made it easier for investors to cash out their investments sooner.
One of the most notable developments is the rise of secondary markets, which provide a way for investors to sell their shares in private companies before they go public. According to a report by Common Fund, secondary transaction volume in the first half of 2021 increased to $48 billion, compared to the first half of 2020 volume of $18 billion. This trend is likely to continue as more and more investors look for ways to cash out of their illiquid investments sooner.
Private market liquidity is often misunderstood. While it’s true that these investments can be less liquid than stocks or other kinds of assets, there are some recent developments that are making it easier for investors to cash out sooner. And, despite the added risk, these investments can still offer attractive returns.
It’s the most wonderful time of the year. Lights are going up around town, kids are eagerly anticipating a break from the scholastic grind, and savvy investors are considering how to position their portfolios for maximum after-tax gains in the years to come. One popular strategy that has traditionally paired well with the festive season is tax-loss harvesting.
Tax-loss harvesting begins with an investor considering their likely tax bill for the year and noticing a higher number than they would like to see, perhaps from selling a big stock winner or business. Rather than foot a hefty tax bill today, investors can sell an investment that has declined in value and use the realized loss to reduce their taxes. This not only eases the temporary burden, but Vanguard estimates that it can improve after-tax returns by above 1% annually, with the largest benefits accruing to the largest taxpayers with net worths above $1.2MM.
To understand why that might be the case, consider an investor, Bob, who makes a $100 investment in a stock that declines in value to $80 over a year (a 20% loss) and subsequently doubles in value to $160 (a 100% gain) before he needs to sell it to retire. Were he to hold that investment to retirement, he would take home $148 net of an assumed 20% capital gains tax rate. If, instead, Bob sells the investment at a 20% loss in the first year, he can use that loss to offset ordinary income or other short-term gains taxed at an assumed 30% tax rate, saving $6 in taxes ($20*30%). If he then reinvests the $80 of proceeds and the $6 tax savings back into a similar investment, that investment could grow to $172 ($86*2) by Bob’s retirement. Even after paying taxes on his gains, Bob walks away with $154.80, or $6.80 more than he would have had holding the investment all the way to maturity. $2 of that is from the lower assumed tax rate, and $4.80 is from Bob’s ability to compound capital for a longer stretch of time before paying any taxes.
There are a couple of simplifications to Bob’s example for investors to consider. First, the difference in Bob’s tax rates between year one and retirement was 10%, which assumed that Bob had short-term capital gains or standard income to offset short-term capital losses. Standard income can only be offset to a maximum of $3,000 annually, though some losses can be rolled. Investors should consult tax professionals to understand the specifics of their situation. Additionally, Bob’s savings rely on the underlying asset’s volatility. Repeating the same exercise with a year-one value of $90 and an exit value of $130 yields only $3.07 of savings. Finally, if Bob sells shares in a stock and purchases shares in the same stock, he will run afoul of IRS rules around “wash sales” and lose his ability to deduct losses from his taxes. Wash sale rules prohibit investors from buying securities that are the same or substantially identical within 30 days of selling below cost, so for Bob to operate within the rules, he would need to either wait for over a month to reinvest and risk prices moving away from him, or invest in a substantially different security with potentially different returns. Investors should consult legal counsel for more specifics.
What does tax-loss harvesting have to do with alternative investments? Alternatives are a great place to park the cash from tax-loss harvesting because of high historic returns, most of those returns coming in the form of long-term capital gains, and no issues with wash sales. Data provider Hamilton Lane looked at 10-year rolling returns from Private Equity and public markets side-by-side and found Private Equity outperformed all three public benchmarks in all but a handful of quarters since 2001. On the private equity side, most of those returns have come from long-term capital gains because investments are typically held for three or more years. They also do not trigger wash trading rules, as each fund has a different mix of portfolio companies.
Tax-loss harvesting comes with some complexities investors should review carefully, but has been shown to increase after-tax returns and free up liquidity. Investors evaluating the strategy should consult tax and legal advisors and carefully consider which investments to rebalance into that steer clear of wash trading rules and provide compelling returns. Alternatives have a role to play in many accredited portfolios and deserve a long look from properly qualified investors.
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Public market investors enjoyed an unprecedented bull run after the great financial crisis. But as interest rates rise and valuations remain stretched, many are finding it difficult to find attractive opportunities in stocks.
As a Credit Suisse report describes, we are entering a “low return world,” with bond returns under inflation and stock returns expected to deliver significantly lower-than-average returns in the future.
But there is a way to capture far higher returns: private equity. The median PE fund returns a 19.5% net IRR. In contrast, the S&P 500’s projected annualized return over the next decade is just 6%.
Private equity isn’t a smaller slice of the economy—the opposite is true. Buyout firms own more than 10,000 U.S. companies, up from fewer than 2,000 in 2000. That’s more than double the number of domestic US-exchange listed public companies. And the buyout industry has grown to $2.5 trillion in assets under management, more than triple its size in 2010.
Moreover, private equity firms are increasingly focused on smaller companies—the bulk of their targets. In 2000, 80% of PE-backed companies were valued at between $25 million and $1 billion. That percentage remained consistent even as the industry ballooned—a sign that smaller businesses have been an essential part of the PE landscape for two decades.
The appeal of private equity is clear: it provides access to a large and growing pool of attractive investment opportunities, many of which are unavailable to public market investors. But there are other benefits as well.
One of the key advantages of private equity is that it provides exposure to a far more diversified pool of companies than the stock market. For example, the S&P 500 index is heavily concentrated in just a few sectors, such as technology, finance, and healthcare. In addition, just ten mega-cap companies make up nearly a third of the index.
In contrast, private equity firms own various companies across sectors and sizes. As a result, they are less exposed to the ups and downs of any one industry or company. And because PE firms own so many businesses, they deeply understand different industries and what it takes to succeed in them.
This advantage becomes especially clear during downturns. In both the dot-com crash and the financial crisis, private equity outperformed the stock market, with less steep drawdowns and quicker recoveries. In the decade following the dot-com crash, private markets won again. On average, PE firms generated annualized returns of 7.5%, compared to just 0.08% for the public market index equivalent.
Beyond the liquidity premium, private equity firms are often better able to identify and invest in companies with sound fundamentals that will eventually rebound—something that public markets, which are focused on quarterly results, often miss.
Investing in the private markets can be a lucrative opportunity for investors looking to diversify their portfolios. But have you considered the potential of GP stakes investing? This often overlooked strategy has gained traction in recent years and offers unique advantages for those seeking exposure to the private markets.
The private markets have traditionally been inaccessible to most individual investors and reserved for institutional players and high-net-worth individuals. However, with the rise of GP stakes investing, more opportunities are opening up for a wider range of investors to participate in this asset class.
GP stakes investing is an alternative investment strategy that presents both immediate returns and long-term growth potential. In simple terms, GP stake funds invest in equity positions in partnership agreements between general partners (GPs) and limited partners (LPs). Limited partners provide capital to the fund and receive a share of ownership in the underlying company. The key benefit of GP stake investing is its combination of short-term capital distributions and diversified downside protection, making it highly attractive for investors looking to capture both current income and profitability over time.
Longer-term profits are realized primarily through management fee waivers, carried interests generated from larger dividends, or contractual adjustments based on changes in value during an exit event. It also provides a buffer against downside risk by choosing investments with stakes locked down alongside LPs for a longer time horizon than other strategies, such as venture capital. Additionally, GPs can realize significant tax benefits when stakes are held for more than two years; this may present additional opportunities from which investors can take advantage when constructing portfolios. All these factors make GP stakes investing a compelling strategy not just for private equity firms but also for individual investors looking to diversify their portfolios or seeking higher returns from their investments.
The history of GP stakes investing can be traced back to the early 2000s when a few limited partners (LPs) and large asset managers began making direct investments in private funds. This method of investing was attractive due to its low cost and lack of legal or regulatory headaches that accompany public markets. As more LPs began to leverage their relationships with GPs and explore this alternative method of investing, GP stakes investing rapidly grew in popularity over the first seven years.
However, the industry really exploded after the Great Recession of 2007-2008, as increased competition and reports of higher returns led many investors to adopt this approach in earnest. By 2016, GP stakes were becoming commonplace because they offered greater flexibility and transparency than traditional private equity investments. With innovation came a heightened level of sophistication too; multiple technology-enabled platforms were launched around this time promising greater liquidity options, standardization, process automation, deal origination support, and more. Today GP stakes enjoy mainstream acceptance among sophisticated investors thanks in part to these advancements as well as an overall shift towards alternative investments like venture capital and private equity.
GP stakes investing is gaining popularity as an alternative for private equity firms to access their industry peers’ fund returns and balance sheets. Firms are turning to GP stakes due to a slowdown in fundraising and the need to generate capital amid limited external financing options. This trend allows cash-strapped fund managers to sell their interests at competitive prices as buyers actively pursue these acquisitions. According to PitchBook News, the number of announcements related to GP stake investments rose by over 20% from 2019-2020, with no signs of slowing down. Additionally, this type of investment offers tax advantages, as GP stakes funds can postpone taxable distributions until portfolios are fully funded.
GP stakes investing is a strategy that pays high returns even during less-than-ideal market conditions. LPs can potentially earn 7-10% returns in the early years of the GP stake fund life cycle, with the potential to reach mid-teen returns when in more mature portfolios. This makes it an attractive investment opportunity for investors who expect steady long-term growth and are patient enough to wait for hefty returns over a decade or longer.
Moreover, the fund provides further benefit as it encompasses a 10+ year life cycle, meaning that LPs don’t have to reallocate to new funds and disrupt their desired distribution model. Furthermore, GP stakes also afford some degree of downside protection through annual management fees, and the carried interest has upside potential – meaning if a firm sells its stake without going on to create another fund, investors could still recover 70-90% of the original cost. Collectively these features make GP stakes investing an attractive option for LPs seeking stable growth opportunities in volatile economic times.
GP stakes investors are well aware that the success of any venture depends on the strength of its management team, and this sentiment definitely applies to private equity investments. Before investing in a GP stake, such investors will carefully analyze the LP-GP relationships established by the firm they’re considering, as well as examine the incentives that are set up for both parties. Additionally, understanding how the GP generates its revenue needs to be clearly understood so that any interested investor can judge whether or not economically sustainable long-term funds can be expected from said investment.
It is also important for potential investors to consider and weigh out any potential risks involved with making a GP stake investment. These include evaluating if the management company has an actionable growth plan to ensure future returns and analyzing whether or not they could sustain a decrease in fund performance relative to market expectations due to unforeseen circumstances like recessions or currency issues. Ultimately, GP stakes investors must make sure that any deal they enter into meets their unique standards and aligns with their long-term goals.
Platforms like Gridline are making it easier than ever for investors to tap into the world of GP Stakes Investing with accessible capital minimums and lower fees. Gridline offers access to top-tier diversified opportunities vetted and curated by experts, providing investors with the tools they need to capitalize on this growing asset class.