Private equity funds have long been considered sophisticated investment vehicles, but recent developments reveal concerning practices that retail investors should understand before committing capital. A Wall Street Journal investigation exposed several problematic trends in the industry that warrant closer examination.
The Secondary Market Markup Strategy
One of the most troubling practices involves exploiting accounting loopholes through secondary market transactions. Some private equity funds purchase stakes from other PE funds at significant discounts on the secondary market, then immediately mark these investments up to their “official” net asset values. This creates an instant paper gain that may not reflect true economic value.
While this practice generates impressive short-term returns on paper, it raises serious questions about the sustainability and authenticity of reported performance. Investors must scrutinize whether these immediate markups represent genuine value creation or merely accounting manipulation.
The Transparency Problem: Tables vs. Footnotes
Federal securities rules require funds to disclose key investment data including cost basis, current fair value, and acquisition dates. However, there's a stark difference in how funds present this information.
The most transparent funds include clear, user-friendly tables in their financial reports that allow investors to easily compare purchase prices with current valuations. Unfortunately, many funds bury this critical data in footnotes, knowing that most retail investors won't dig through dense regulatory language to find it.
This practice serves dual purposes for fund managers. First, it obscures potentially embarrassing discrepancies between purchase prices and reported values from retail investors. Second, it protects competitive intelligence from rival funds who study these filings to inform their own secondary market strategies.
Encouragingly, some funds are responding to investor pressure for greater transparency. Cliffwater, for example, has committed to moving their pricing data from footnotes to clear tables in their upcoming June 2025 reports, demonstrating that investor advocacy can drive positive change.
Quality vs. Quick Gains: The Secondary Selection Dilemma
The secondary market strategy reveals a fundamental tension in private equity investing. Funds can pursue two distinct approaches:
The Quick Markup Strategy: Purchase low-quality deals at steep discounts to generate immediate paper gains. While this creates impressive short-term performance metrics, it often leads to disappointing long-term returns as the underlying investments fail to perform.
The Quality-Focused Approach: Target high-quality secondaries that trade at more modest discounts (i.e., 5-10%). This approach sacrifices immediate dramatic markups in favor of more sustainable, consistent returns over time.
Investors should strongly favor funds pursuing the latter strategy, even if their quarterly reports appear less exciting initially. Sustainable value creation trumps accounting gimmicks every time.
The Carry Fee Trap: Paying for Paper Profits
Perhaps the most egregious practice in the 40 Act private equity space involves charging carry fees on unrealized gains. This means investors pay performance fees on paper profits that may never materialize into actual returns.
No sophisticated institutional investor would accept such terms, understanding that unrealized gains—especially those created through immediate markups—may prove fictitious over time. The practice essentially allows fund managers to extract fees based on their own valuation assumptions rather than proven investment performance.
This creates a dangerous misalignment of incentives where managers benefit from aggressive markups regardless of ultimate investment outcomes. Retail investors should absolutely avoid any fund that charges carry fees on unrealized gains.
Investment Implications and Red Flags
When evaluating private equity funds, investors should watch for several warning signs:
Lack of transparency: Data buried in footnotes rather than clearly presented.
Excessive secondary markups: Large immediate gains that seem too good to be true.
Carry on unrealized gains: Performance fees charged before actual profits are realized.
Inconsistent returns: Dramatic short-term gains followed by poor long-term performance.
Conclusion
The private equity industry's growth has brought both opportunities and risks for retail investors. While these funds can provide access to attractive investment strategies traditionally reserved for institutions, the practices highlighted above demonstrate the importance of careful due diligence.
Investors should prioritize transparency, sustainable investment strategies, and aligned fee structures over flashy short-term returns. The most successful private equity investments typically come from funds that focus on fundamental value creation rather than accounting optimization.
As the industry continues to evolve, regulatory scrutiny and investor pressure will likely drive improvements in disclosure and alignment. Until then, caveat emptor remains the watchword for anyone considering private equity investments. The key is distinguishing between genuine alpha generation and sophisticated marketing dressed up as investment performance.
By demanding transparency, questioning immediate markups, and avoiding funds that charge carry on unrealized gains, investors can better position themselves to benefit from private equity's legitimate opportunities while avoiding its most problematic practices.
Larry Swedroe is the author or co-author of 18 books on investing, including his latest Enrich Your Future. He is also a consultant to RIAs as an educator on investment strategies.
Hi Larry - could we chat about your views? I think you’re onto something big.
IMO should never charge on gains cannot realize as no way to know if ever will be, allows for mismatch of interests between sponsors and investors. No institutions I know of allow that. For what it is worth I try to avoid funds that have any incentive fees, and the more are no available like from Cliffwater and Aksia/Calamos and Stepstone and even Hamilton Lane's new Infratstructure fund