For our latest episode, Martin Schmalz joined us for a conversation on neglected risks in private markets. Schmalz is a Professor of Finance, Economics, and Real Estate at Oxford’s Saïd Business School.
As we publish this on July 4th, we also wish the United States a happy 250th birthday and express our admiration for the Founding Fathers: visionary philosophers who became practical nation-builders.
Reported returns overstate what investors actually earn: IRRs are measured from the capital call, not the commitment, and subscription lines, NAV loans, and unfunded commitments inflate the headline number while quietly adding leverage
Private markets diversify less than advertised and cost more than they seem: a single fund is a concentrated bet on a manager, not an “asset class”. Opaque and layered fees are paid for longer than investors expect
Risks may be neglected due to agency conflicts or beliefs, for example obscured by an insurance–private-credit nexus leaning on biased ratings
We should be concerned about “democratizing” access to private assets when even ultra-high-net-worth-individuals routinely fall victim to private-market traps
Returns have been falling as the illiquidity premium erodes: private-credit yields have compressed from roughly 10% to 6%. As capital has flooded in private market funds prices increased, implying lower expected returns going forward
Advertised IRRs are not what investors earn: they are computed from the moment that fund managers (General Partners – GPs) call for the pre-committed capital from outside investors (Limited Partners – LPs), not from when the capital is committed
Holding the committed-but-uncalled capital in cash can impose a significant drag on returns. LPs effectively write the General Partners an unpriced option and bear a cash drag that is hard to value (Gourier et al., 2024)
Three devices widen the gap between realized returns and IRRs:
1. Subscription lines of credit: Early in a fund’s life the GP borrows from a bank to make an investment instead of calling LP capital, then calls that capital a year or two later. The deal’s return is unchanged, but it is now earned over a shorter time, so the measured IRR rises (ILPA, 2017)
2. Net-Asset-Value loans: Late in a fund’s life the GP borrows against the accounting value of the portfolio to fund redemptions or new purchases. This increases leverage, risk, and the IRR without touching the underlying value
3. Unfunded commitments: Investors pledge capital to future funds they cannot yet fund, so even a family office whose policy statement forbids leverage can run hidden leverage off balance sheet, understating portfolio risk (Jansen et al., 2024).
[26:47] Diversification myths and concentration risk
The idea that “private equity diversifies your portfolio” is often asserted without evidence: there are no monthly returns to compute correlations with other assets, and any diversification or risk-adjusted performance can only be observed ex-post (Schmalz and Zhuk, 2019; Franzoni and Schmalz, 2017)
In practice portfolios are concentrated: heavy in SaaS and AI infrastructure, and not marked-down when public comparables fall
Buying one fund is a concentrated bet on a manager, not exposure to an “asset class.” That matters because returns are right-skewed: in public markets Bessembinder (2018) finds ~4% of firms account for all net wealth creation above T-bills, so investors must “buy the haystack”. Most family offices are too small to write enough tickets to do that, so they take uncompensated idiosyncratic risk.
Fees are opaque, with account, management, placement, and carry fees being stacked in a “Russian-doll style”
Hortaçsu and Syverson (2004) famously showed that there was a large fee dispersion in identical S&P 500 index funds, and attributed this to investors’ imperfect information
The same is happening with private assets. Goldman charged 1.25% management fee plus 17.5% carry for access to investing in Anthropic while Morgan Stanley offered the same round at a one-off 1% management fee (FT, 2026)
As distributions stall and holding periods lengthen, investors are also not aware of how long they will pay fees (Strebulaev, 2026)
Private “debt” is more equity-like than it looks: roughly a fifth of these portfolios is preferred stock, equity, or warrants whose payoff tracks the borrower’s share price. After controlling for the embedded equity risk private credit’s alpha disappears (Erel, Flanagan and Weisbach, 2024)
Fund liquidity is an illusion once redemptions are correlated: a 5%-a-year redemption right feels ample to any one investor, but when everyone runs at once funds gate withdrawals as illiquid loans can’t be conjured liquid on demand
Insurers now hold roughly a fifth of their fixed income assets in private credit and are increasingly cross-owned by the fund sponsors. They are leaning on overoptimistic private ratings to reduce their capital requirements (Li et al., 2026)
Genuinely good advice (personalized, independent, and competent) doesn’t scale, so it barely exists. We lack research on optimal long term investment strategies (Cochrane 2022 is an un-personalized first step) so it is hard to evaluate advisors
Illiquidity, although it prevents accurately measuring diversification, may be a commitment device. People are more averse to imminent risks (Eisenbach and Schmalz, 2016) so in liquid but crashing markets they panic-sell; a lockup ties their hands. On one reading investors rationally pay for that discipline; on another they simply underestimate the risk (Eisenbach and Schmalz, 2018)