Why Selectivity Matters in Private Markets
Why Selectivity Matters in Private Markets
By Mr. J. Oliver, CPA, CFA, MBA
Chief Executive Officer, LIAM
Private markets have become an increasingly important part of the global investment landscape.
Private equity, private credit, infrastructure, real estate, venture capital, growth capital, direct investments, and other non-public strategies now occupy a meaningful place in the portfolios of institutions, family offices, endowments, sovereign investors, and sophisticated private investors.
That growth has created opportunity.
It has also created a misconception.
Access to private markets is not, by itself, a source of superior returns.
The fact that an investment is private does not make it attractive. Illiquidity does not guarantee a premium. Complexity does not automatically create value. A well-known sponsor does not remove underwriting risk. And a compelling presentation does not compensate for a weak capital structure, unrealistic assumptions, poor governance, or excessive valuation.
At LIAM, we believe private markets reward selectivity.
The opportunity set can be broad, but capital should be allocated narrowly and deliberately.
The challenge is not simply finding private investments.
It is identifying the private investments that justify giving up liquidity, transparency, flexibility, and, in many cases, a meaningful degree of control.
Private markets are not one asset class
The phrase “private markets” can make the space sound more uniform than it really is.
It is not.
Private equity can include leveraged buyouts, growth equity, venture capital, direct investments, co-investments, and secondary transactions.
Private credit can include senior lending, asset-backed finance, mezzanine strategies, opportunistic credit, distressed situations, specialty finance, and structured lending.
Real assets can include infrastructure, real estate, energy, transportation, communications assets, logistics, and other tangible investments.
Each area has different return drivers, leverage profiles, liquidity constraints, valuation methodologies, time horizons, and risk characteristics.
An investor who approaches private markets as a single allocation category can miss those distinctions.
The more useful approach is to ask what each investment actually does inside the portfolio.
Illiquidity should be compensated
One of the defining characteristics of many private investments is that capital may be locked up for years.
That should matter.
When investors give up liquidity, they are giving up flexibility.
They may not be able to sell when the investment thesis deteriorates.
They may not be able to rebalance when market conditions change.
They may be required to meet capital calls during periods when liquidity elsewhere is constrained.
They may have little influence over the timing of an exit.
That means an illiquid investment should offer a compelling reason for the investor to accept those limitations.
The expected return should justify the loss of flexibility.
The structure should justify the commitment.
The underlying opportunity should be sufficiently differentiated.
In our view, illiquidity should be earned.
The illiquidity premium is not automatic
Investors often hear that private markets offer an “illiquidity premium.”
That can be true in certain situations.
But it should not be assumed.
If too much capital competes for the same assets, expected returns can be compressed.
If entry valuations rise, future returns can decline.
If leverage becomes more aggressive, downside risk can increase.
If fees are high, gross returns can look attractive while net returns disappoint.
If the investment is marked infrequently, apparent stability may hide economic volatility.
Illiquidity can create the possibility of additional return.
It does not create it automatically.
The dispersion of outcomes can be wide
Private-market returns can vary substantially across managers, sectors, vintages, geographies, and deal structures.
That makes selectivity especially important.
Two funds with similar strategies can produce very different outcomes.
Two businesses in the same industry can have very different operating quality.
Two private-credit transactions with the same headline yield can have radically different recovery prospects.
Two real-estate investments in the same city can produce different returns because of leverage, lease quality, financing terms, operating efficiency, and exit timing.
The broad label matters less than the underlying underwriting.
Access is not the same as advantage
Private investments are often marketed around access.
Exclusive access.
Proprietary deal flow.
Off-market opportunities.
Relationship-driven sourcing.
Those can be useful advantages, but access alone is not enough.
A poor investment does not become attractive because it is hard to access.
The investor still needs to understand the fundamentals, the valuation, the capital structure, the incentives, and the likely return after fees.
True advantage comes from judgment.
Entry price still matters
Private markets are not exempt from valuation discipline.
A strong company can be a poor investment if purchased at too high a price.
Likewise, an attractive sector can become less compelling if too much capital pushes entry valuations beyond reasonable assumptions.
High entry multiples increase the amount of operating improvement required to generate acceptable returns.
They can also increase dependence on favorable exit conditions.
Investors should ask:
How much of the projected return comes from business improvement?
How much comes from leverage?
How much depends on multiple expansion?
How much depends on a favorable exit environment?
The answers matter.
Multiple expansion should not be the investment thesis
Private-equity models can sometimes rely heavily on the assumption that a business will be sold at a higher valuation multiple than the one paid at entry.
That may happen.
It should not be the foundation of the investment case.
A stronger underwriting framework assumes that returns should primarily come from business growth, margin improvement, cash-flow generation, and deleveraging.
Multiple expansion should be treated as upside, not as a necessity.
If the investment only works because the market is expected to pay more later, the margin of safety may be weak.
Leverage can improve returns—and magnify mistakes
Leverage is common in private markets.
Used thoughtfully, it can improve capital efficiency.
Used aggressively, it can amplify downside.
Debt obligations remain even when revenue slows.
Interest expense can rise.
Refinancing conditions can deteriorate.
Covenants can tighten.
Asset values can fall.
A company with a sound business model can still face financial stress if its capital structure is too aggressive.
That is why investors should examine debt maturities, interest coverage, covenant protection, refinancing assumptions, fixed-versus-floating rate exposure, and the sensitivity of cash flow to higher funding costs.
Capital structure is part of the investment thesis.
Cash flow matters more than narrative
Private investments are often supported by polished presentations, market studies, forecasts, and strategic plans.
Those materials can be useful.
But economic value ultimately depends on cash flow.
Can the business generate sustainable free cash flow?
How predictable are revenues?
How concentrated are customers?
How cyclical are margins?
How much capital must be reinvested?
How dependent is the business on continued financing?
What happens if growth slows?
What happens if costs increase?
What happens if the exit is delayed?
Those questions tend to matter more than the elegance of the presentation.
Underwriting the downside is essential
Because private investments may not be easily sold, downside analysis should be more rigorous, not less.
Investors should understand what can go wrong.
Operational risk.
Customer concentration.
Technology disruption.
Regulatory change.
Commodity sensitivity.
Interest-rate exposure.
Currency exposure.
Management execution.
Financing risk.
Litigation.
Capital requirements.
Exit risk.
The investor should know what protects capital if the original thesis proves too optimistic.
A compelling upside case is useful.
A credible downside case is essential.
The downside scenario should be realistic
It is easy to create a model where revenue is slightly lower and margins are only modestly compressed.
That may not be a true downside case.
A useful stress test should examine what happens if:
revenue falls sharply;
refinancing becomes difficult;
interest costs increase;
a major customer is lost;
working-capital needs rise;
the exit market remains closed for longer than expected;
or a key operational assumption fails.
Private-market underwriting should not simply ask, “What happens if things are a little worse?”
It should ask, “What happens if the investment environment becomes genuinely difficult?”
Governance can materially affect outcomes
Private investments can vary substantially in governance quality.
Board rights.
Information rights.
Minority protections.
Voting rights.
Consent provisions.
Reporting obligations.
Related-party transactions.
Management incentives.
Distribution policies.
These details can materially affect investor outcomes.
A strong business with weak governance can still become a poor investment.
Selectivity therefore applies not only to the asset itself, but also to the legal structure around it.
Alignment matters
Private-market outcomes often depend heavily on the incentives of sponsors, managers, founders, executives, and investors.
How much capital does the sponsor have at risk?
How is management compensated?
Are incentives tied to sustainable value creation?
Does the sponsor earn substantial fees regardless of performance?
Are there transaction fees or monitoring fees that create conflicts?
How is carried interest structured?
These questions influence behavior.
Good alignment cannot guarantee success.
Poor alignment can materially increase risk.
Private credit requires credit discipline
Private credit has attracted substantial attention because of its potential for income, floating-rate exposure, and negotiated lender protections.
But lending privately does not remove credit risk.
Investors must still ask:
Can the borrower repay?
How strong is the collateral?
How much leverage exists?
What covenants protect lenders?
How senior is the position?
What happens in a restructuring?
What is the expected recovery?
What is the borrower’s access to additional liquidity?
Yield should never be viewed independently from default and recovery risk.
High yield can be a warning, not an opportunity
A very attractive coupon can create excitement.
But higher yield often exists for a reason.
The borrower may be more leveraged.
The collateral may be weaker.
The transaction may be structurally subordinate.
The market may be pricing in significant default risk.
Investors should therefore ask not only, “What is the yield?”
They should ask, “Why is the yield this high?”
That distinction is critical.
Private equity requires operating realism
Private-equity returns often depend on some combination of revenue growth, margin improvement, debt reduction, and exit valuation.
Those assumptions should be realistic.
A model that requires aggressive growth, expanding margins, rapid deleveraging, and a higher exit multiple may look attractive on paper.
It may also leave little room for error.
A stronger investment case usually contains several independent sources of value creation.
It does not depend entirely on a favorable market.
Venture capital requires a different risk mindset
Venture investing presents its own challenges.
Returns can be highly concentrated.
Many investments may fail.
A small number of outcomes may drive the majority of portfolio performance.
That makes diversification, entry valuation, ownership discipline, follow-on reserves, and portfolio construction especially important.
Investors should not assume that participation in a high-growth sector automatically creates attractive returns.
The entry price still matters.
The quality of the business still matters.
The probability of dilution still matters.
The availability of future funding still matters.
Real assets require operating and financing analysis
Real estate and infrastructure are often viewed as stable, tangible investments.
But they can carry significant operating and financing risk.
Investors should examine:
tenant quality;
lease duration;
occupancy;
maintenance requirements;
capital expenditures;
energy costs;
regulation;
financing terms;
refinancing schedules;
and sensitivity to interest rates.
A tangible asset is not automatically a low-risk asset.
Exit assumptions matter
Private-market returns are not realized until liquidity occurs.
That makes the exit important.
What is the expected route?
A strategic sale?
A sale to another sponsor?
An initial public offering?
A refinancing?
A recapitalization?
What happens if the exit takes longer?
What happens if valuations decline?
What happens if financing markets tighten?
Investors should distinguish between a strong business and a favorable exit assumption.
The two are not always the same.
Duration risk deserves more attention
Private investments are often described using expected holding periods.
Those periods can extend.
A five-year investment can become seven years.
A seven-year fund can take much longer to return capital.
That extension can affect liquidity planning, internal-rate-of-return calculations, and the investor’s ability to redeploy capital.
Duration is not merely an administrative detail.
It is part of investment risk.
IRR can sometimes hide duration
Internal rate of return is commonly used in private markets.
It is useful, but it can also be misunderstood.
Two investments can have the same IRR but very different total-value outcomes.
An investment that returns capital quickly can show a strong IRR even if the absolute gain is modest.
Another investment may generate significant total value but over a longer period.
Investors should therefore examine both IRR and multiple on invested capital, along with actual cash-flow timing.
No single return metric should dominate the analysis.
Capital calls can create portfolio pressure
Committed capital is not the same as invested capital.
Private funds may call capital over time.
That creates future obligations.
During market stress, those obligations can become more important because public-market assets may be falling at the same time.
An investor may therefore be required to fund private commitments while liquid assets are under pressure.
That is why private allocations must be integrated with broader liquidity planning.
Overcommitment can become dangerous
Some investors intentionally commit more capital than they currently hold in cash, assuming that distributions from existing private investments will fund future capital calls.
That strategy can work.
It can also create problems if distributions slow.
If exit markets close and capital calls continue, the investor can face a liquidity mismatch.
Overcommitment should therefore be managed carefully.
Liquidity stress tests matter.
Vintage diversification matters
Private investments are often made over multiple years.
That creates vintage-year exposure.
Investing too heavily during one period can create concentration.
Entry valuations may be unusually high.
Financing conditions may be unusually easy.
Certain sectors may dominate.
By spreading commitments over time, investors can reduce dependence on a single environment.
Selectivity applies to timing as well as to individual investments.
Manager selection is critical
Private-market managers can differ materially in sourcing capability, underwriting discipline, operating expertise, governance, network strength, and exit execution.
Past performance is useful, but it should not be viewed in isolation.
Investors should ask how those returns were generated.
Was performance driven by operating improvement?
Leverage?
Multiple expansion?
Sector concentration?
A favorable vintage?
One unusually successful investment?
The source of past returns matters.
Track records need context
A manager can have an impressive historical return and still present meaningful risk.
If most of that return came from one deal, the track record may be less repeatable.
If the manager benefited from a period of falling interest rates, the same strategy may be less effective in a different environment.
If the strategy relied heavily on leverage, future results may depend on financing conditions.
Performance numbers should always be connected to process.
Team stability matters
A private-market track record belongs not only to a firm, but also to the people who created it.
Investors should understand whether the individuals responsible for historical performance are still involved.
Has the team changed?
Has the strategy changed?
Has the fund size grown significantly?
Has decision-making become more centralized?
Has sourcing changed?
An excellent historical track record may be less relevant if the people, process, or scale have changed materially.
Fund size can change the opportunity set
As private-market managers become successful, their funds often grow.
That can create a challenge.
A strategy that worked well with a smaller fund may need to invest in larger transactions once assets under management increase.
That can change the opportunity set.
It can reduce flexibility.
It can increase competition.
It can move the manager away from the niche that originally created the advantage.
Investors should ask whether the strategy remains scalable.
Fees matter
Private-market fee structures can be complex.
Management fees.
Carried interest.
Transaction fees.
Monitoring fees.
Fund expenses.
Performance allocations.
Administrative costs.
Over long holding periods, these can materially affect returns.
Gross performance may look attractive.
Net performance determines the investor’s outcome.
Fee transparency should be part of the underwriting process.
Fee complexity can obscure economics
Investors should understand not only the headline fee percentage, but also when the fee is charged and on what base.
Committed capital?
Invested capital?
Net asset value?
Gross assets?
Different methods can produce very different economics.
The same is true for carried interest and preferred returns.
Small structural differences can materially affect net outcomes over time.
Co-investments can be attractive—but not automatically
Co-investments are often appealing because they may offer lower fees and greater exposure to specific transactions.
But they can also create concentration.
Investors may receive less time to conduct due diligence.
The opportunity may be offered because the sponsor wants to share risk.
Co-investments should therefore be underwritten independently.
A deal should not become attractive simply because a trusted manager is participating.
Direct investing requires institutional capability
Family offices and institutions increasingly consider direct private investments.
Direct ownership can offer control, transparency, and lower fee structures.
But it also requires meaningful internal capability.
Sourcing.
Due diligence.
Legal analysis.
Financial modeling.
Governance.
Monitoring.
Operational oversight.
Exit planning.
Direct investing should not be pursued simply to avoid fund fees.
The investor must have the resources to perform the work that the fund manager would otherwise perform.
Secondary markets can create opportunity
Private-market secondaries can provide liquidity to existing investors and create entry opportunities for new buyers.
In some environments, secondary interests may be available at discounts.
But discounts alone do not make an investment attractive.
The underlying portfolio quality, remaining duration, unfunded commitments, manager quality, and expected distributions still matter.
A discount to a weak asset is not necessarily value.
Valuation smoothing should not be confused with lower risk
Private assets are not priced every second.
That can make reported volatility appear lower than public markets.
But lower reported volatility does not necessarily mean lower economic risk.
Private valuations may adjust more slowly.
That can make portfolios appear more stable during stress.
Investors should distinguish between valuation frequency and underlying risk.
Illiquidity can hide volatility.
It does not eliminate it.
Stale valuations can affect asset allocation
When public markets fall sharply, private-market valuations may adjust more slowly.
That can temporarily make private assets appear to represent a larger percentage of the portfolio.
The investor may then appear overallocated to private markets even before the private marks fully reflect the new environment.
This can affect rebalancing and liquidity decisions.
A sophisticated allocation process should account for valuation lag.
Deal flow should not dictate allocation
Investors sometimes allow opportunities to determine portfolio construction.
A private deal arrives.
It looks interesting.
Capital is available.
The investment gets made.
Repeated over time, this creates a collection of deals rather than a portfolio.
The better sequence is the opposite.
First determine the desired allocation, liquidity budget, sector limits, risk tolerance, and return objective.
Then evaluate whether a particular opportunity deserves a place within that framework.
Concentration can build quietly
Private portfolios can become concentrated without investors fully realizing it.
Several funds may own similar companies.
Multiple managers may be exposed to the same sector.
A family office may already have significant exposure through an operating business.
Look-through analysis is essential.
The headline fund names may differ while the underlying economic exposures remain similar.
Geographic concentration matters too
Private-market portfolios can become concentrated by geography.
That can introduce regulatory, currency, political, and economic risks.
Even when investments are diversified by sector, they may still depend heavily on one country or region.
A whole-portfolio view should consider geographic exposure as well.
Currency risk can materially affect returns
Cross-border private investments can create currency exposure.
That risk may be hedged or unhedged.
It may be embedded at the company level, the fund level, or the investor level.
Currency movements can materially influence realized returns.
Investors should understand whether currency risk is part of the thesis or simply an unintended exposure.
Selectivity includes the decision to wait
Investors sometimes feel pressure to deploy committed capital quickly.
That pressure can reduce standards.
Waiting can be an investment decision.
If valuations are unattractive, structures are weak, or downside protection is insufficient, preserving liquidity may be preferable to forcing capital into an opportunity.
There is no requirement that every available dollar be invested immediately.
Discipline includes patience.
Dry powder can be valuable
Uninvested capital is sometimes viewed as a drag on returns.
But liquidity can create optionality.
When markets dislocate, investors with available capital can move quickly.
That flexibility can be valuable in private markets, where the best opportunities often emerge when other investors are constrained.
Dry powder should not be excessive.
But it should not automatically be viewed as inefficient.
Portfolio fit can matter more than standalone attractiveness
An investment can be excellent on its own and still be inappropriate for a particular investor.
A family office heavily exposed to real estate may not need additional property exposure.
An institution with significant private equity commitments may value private credit differently.
An investor with near-term liquidity needs may need to limit long-duration assets.
Suitability is always relative.
Private-market portfolio construction should be intentional
A thoughtful private-market portfolio may consider:
strategy diversification;
sector diversification;
geographic diversification;
manager diversification;
vintage diversification;
liquidity;
capital-call timing;
fund size;
and expected duration.
The objective is not diversification for its own sake.
It is to avoid allowing one hidden risk to dominate the entire private allocation.
The strongest private investments often solve several problems at once
The most attractive opportunities may combine multiple favorable characteristics.
A strong underlying business.
A reasonable valuation.
Conservative leverage.
Aligned management.
Clear governance.
Visible cash flow.
Multiple exit pathways.
Adequate downside protection.
A defined role in the portfolio.
It is rare to find all of these simultaneously.
That is exactly why selectivity matters.
Complexity is not the same as sophistication
Private-market structures can be complex.
Complexity can sometimes create opportunity.
But it can also obscure risk.
An investment should not be considered sophisticated simply because it is difficult to understand.
In fact, the inability to clearly explain how an investment makes money can itself be a warning sign.
A good investment thesis should ultimately be understandable.
Documentation matters
In private investing, economic outcomes can depend heavily on contractual details.
Covenants.
Distribution waterfalls.
Preferred returns.
Liquidation preferences.
Conversion rights.
Voting rights.
Redemption provisions.
Fee offsets.
Investor protections.
These terms should be understood before capital is committed.
The legal structure can materially influence the economics.
Due diligence is more than financial analysis
Private-market due diligence should include more than reviewing financial statements.
Operational due diligence.
Background checks.
Legal review.
Reference checks.
Technology review.
Cybersecurity.
Regulatory compliance.
Governance.
Valuation policy.
Service providers.
These factors can materially affect investor outcomes.
Operational risk can be underestimated
A strong strategy can still fail because of weak operational controls.
Poor valuation procedures.
Weak accounting systems.
Insufficient compliance.
Key-person dependence.
Cybersecurity vulnerabilities.
Unreliable reporting.
These issues may not appear in the headline return model, but they can materially damage value.
Transparency should be demanded
Private investments often offer less transparency than public-market securities.
That makes reporting quality important.
Investors should expect clear information on:
performance;
valuation;
capital calls;
distributions;
portfolio exposures;
risk;
and material developments.
Limited transparency should not be accepted simply because the investment is private.
Scenario analysis matters
Private investments should be tested under multiple environments.
What happens if interest rates stay high?
What happens if revenue falls?
What happens if refinancing markets close?
What happens if the exit is delayed?
What happens if labor costs rise?
What happens if regulations change?
The objective is not to predict the future.
It is to understand the range of possible outcomes.
Private markets require patience—but not complacency
Long holding periods can encourage disciplined investing.
They can also create complacency.
Because investors cannot easily sell, they may be tempted to stop questioning the original thesis.
That is a mistake.
Private investments should still be monitored.
Assumptions should be revisited.
Management performance should be evaluated.
Governance should be reviewed.
Patience is not the same as passivity.
Selectivity is a form of capital preservation
Every investment declined because valuation is too high, leverage is too aggressive, governance is too weak, or downside protection is inadequate preserves capital for another opportunity.
That optionality has value.
A disciplined investor does not need to participate in every attractive story.
Capital is finite.
Opportunity is not.
At LIAM, the emphasis is on portfolio fit
At LIAM, we believe private markets can play an important role in sophisticated portfolios.
They can provide access to differentiated businesses, contractual cash flows, real assets, long-duration opportunities, and structures unavailable in public markets.
But private markets should not be treated as an automatic allocation.
The investment must earn its place.
That means evaluating the opportunity itself and the role it plays within the broader portfolio.
It means understanding liquidity.
It means understanding leverage.
It means understanding governance.
It means understanding valuation.
And it means being willing to say no.
Access is useful. Judgment is more valuable.
The growth of private markets has made opportunities more accessible.
But access alone is not an investment advantage.
Judgment is.
The ability to distinguish between a compelling business and a compelling investment.
The ability to separate a strong manager from a favorable market cycle.
The ability to understand when complexity creates opportunity and when it merely disguises risk.
The ability to recognize when expected return does not justify illiquidity.
Those distinctions matter.
Private capital should earn its illiquidity
For long-term investors, private markets can be a powerful component of a diversified investment framework.
But capital committed privately gives up something valuable: flexibility.
That sacrifice should be compensated by the quality of the opportunity.
The strongest private-market portfolios are not necessarily those with the greatest number of investments.
They are those where each investment has been selected deliberately, underwritten carefully, and integrated thoughtfully into the broader portfolio.
At LIAM, that is how we believe private markets should be approached.
Not with the objective of maximizing exposure.
With the objective of maximizing the quality of the capital allocation.
Because in private markets, perhaps more than anywhere else, the investments an investor declines can be just as important as the ones they pursue.
Disclaimer: This material is provided for general informational and educational purposes only and does not constitute investment, legal, accounting, or tax advice, nor an offer, recommendation, endorsement, or solicitation to buy, sell, or hold any security, private investment, fund interest, or financial product. Private-market investments may involve substantial risks, including illiquidity, loss of capital, valuation uncertainty, leverage, limited transparency, concentration, operational risk, and long holding periods. Investors should evaluate their own objectives, circumstances, liquidity requirements, risk tolerance, and applicable legal or regulatory requirements and obtain appropriate professional advice before making investment decisions.