The Democratization of Private Assets with ETFs

Overview:

• Private asset ETFs offer exposure to private credit with benefits like diversification and professional management.
• ETFs can introduce more price transparency and secondary liquidity than private assets.
• The ETF industry is working to address challenges including the liquidity mismatch between the ETF structure and its illiquid holdings, making private asset ETFs a potentially groundbreaking addition to the market.

The Democratization of Private Assets

Once upon a time, exchange-traded funds (ETF) democratized access to bonds, an unlisted security that was harder to access than stocks. At the time, many skeptics doubted whether the ETF structure could handle a non-lit market. However, the ETF structure proved to be well suited for bonds. Today, fixed income ETFs represent nearly 30% of ETF Assets Under Management (AUM) in Canada and continue to grow rapidly. Now, the next frontier for ETFs is emerging with a recent filing that aims to list the world's first ETF with significant exposure to private markets.

Private market assets include private equity, venture capital, private credit, real estate and infrastructure – investments in privately owned, rather than publicly traded, assets. Skeptics have already voiced concerns, but ETFs are no stranger to skepticism. Although incorporating illiquid assets within a liquid structure presents challenges, many of which lie on the market-making side, the ETF ecosystem is eager to explore how the ETF structure can yet again democratize access to a new asset class.

Last month, a large U.S. asset manager, together with a private equity giant, filed to launch the first private credit ETF. Although private assets have entered the conversation alongside ETFs previously, this is the first major filing with significant concentration to private assets. In addition, several large U.S. asset managers are also exploring ways to make private assets more accessible to investors using the ETF wrapper.

Private assets are one of the fastest-growing sectors in finance, offering benefits including diversification, enhanced returns and less exposure to short-term volatility. Over the last decade, AUMs have more than tripled to ~US$13 trillion in 2023 (Source: McKinsey). This upward trajectory is set to continue, with analysts at Preqin predicting AUM to surpass $18.3 trillion by 2027 (Source: The World Economic Forum). This rapid growth has attracted ETF giants to tap into the market and stay at the forefront.

As ETFs for private assets come ashore, it's important to consider the potential challenges, benefits and broader impact of this development. Questions remain around issues like potential Net Asset Value (NAV) dislocations, arbitrage of illiquid assets and liquidity in private assets. The democratization of an asset class is not without its challenges, but it marks another pivotal moment for ETFs.

ETF Solutions for Private Assets

ETF issuers have been looking for ways to access private markets for years. While several ETFs provide exposure to business development companies (BDCs) and private equity firms, none have significant investments in private assets. There are a few ETFs today that invest in private equities, but that exposure is often so minimal that market makers can simply ignore it. However, this is likely to change soon given the new filing.

According to the filing, the ETF will invest at least 80% of the fund’s net assets in a portfolio of investment-grade debt securities including a combination of public credit-related investments and private credit investments sourced by a private equity company. The fund intends to invest up to 15% of its net assets in private credit, which aligns with the U.S. 1940 Act's allowance for funds to hold 15% of their portfolios in illiquid assets. This ETF is still awaiting regulatory approval.

Potential Benefits of Private Asset ETFs

Once launched, private asset ETFs will give investors easier access to the private assets and potentially create a more accessible and transparent marketplace with several potential benefits.

Accessibility

Retail investors who cannot access private assets directly or without a lock up can use private asset ETFs to access the market. Institutional investors can also use private asset ETFs for strategic and/or tactical allocation purposes. Unlike individual private asset investments, which often requires a large initial investment amount, private asset ETFs allow investors to enter the market with a relatively lower investment.

Diversification

Most private asset ETFs are likely to invest in a broad range of private assets providing exposure to several assets and reducing the risks of a single issuer. This can allow investors to benefit from the overall growth of the private asset industry.

Professional Management

Most investors lack experience in private assets, making professional management crucial. Private asset ETFs offer access to the expertise of the fund managers who select investments, monitor risks and manage the fund's operations.

Price Transparency

For most investors, private assets are difficult to value due to their lack of transparency and limited trading activity. Private asset ETFs, however, are expected to offer more accurate valuations during trading hours. Although it is still early in the process of creating these products, the ETF structure will likely push the private markets industry toward more readily available valuations. In the meantime, the ETF industry will develop methods to fairly value illiquid assets on a daily basis. The appropriateness and accuracy of the fair valuing approach is yet to be seen, but the ETF industry is undoubtedly going to work towards improving price discovery in private assets.

Additional Liquidity

While private assets are valued for their illiquidity premium, this also makes it harder for investors to access their cash. Private asset ETFs, once launched, will trade on exchanges, offering liquidity during trading hours. In addition to the primary liquidity provided by the fund issuer and its private asset liquidity provider, private asset ETFs will also benefit from secondary liquidity on the exchange where natural buyers and sellers of the ETF itself provide liquidity, often without any need to trade the underlying assets. The multiple levels of liquidity offered by the ETF structure will be viewed as a key feature of these new ETFs enhancing their appeal to investors.

Potential Challenges of Private Asset ETFs

Despite the promising potential of private asset ETFs, these products may face several hurdles.

Illiquid Assets in a Liquid Wrapper

The biggest concern for private asset ETFs is the liquidity of the underlying assets. ETFs are known for their liquidity allowing easy buying and selling. In contrast, private assets often lack intraday liquidity. The liquidity mismatch between the underlying assets and the ETF vehicle makes intraday trading and pricing challenging. The liquidity of an asset plays on its transactable prices. In times of market distress, even if the ETF has a liquidity provider, the valuation of that asset will come under pressure as supply increases, leading to pricing variability. This could result in higher create/redeem fees for ETF buyers and sellers and reflecting the challenges of pricing these assets. Many bond ETFs experienced discounts to their NAV and ballooning create/redeem fees during the pandemic as ETFs strived to reflect the true pricing of the underlying bonds. Private asset ETFs could face similar illiquidity discounts in times of distress.

Regulatory Approval

The new filing is still pending regulatory approval. To address the challenges in private asset pricing, the private equity company has pledged to provide intra-day, executable firm bids on illiquid assets. It may mitigate the liquidity risk of private asset ETFs, which is a key concern for regulators like the SEC.

Modest Private Asset Exposure

It is important to highlight that the proposed ETF will only invest a small portion of its portfolio in private assets. For investors looking for a portfolio fully investing in private assets, this ETF may not be suitable.

Market Making Challenges

Private asset ETFs will present unique challenges for ETF market makers. Providing continuous quotes for ETFs holding illiquid assets can be very challenging. Currently, the most common way to quote on these assets is to use a proxy basket that market makers can track or to value them as fixed-price assets. Market makers are still likely to face higher regulatory costs and basis risks if the hedging and pricing are based on a proxy basket, which is likely to be the case. Even if the ETF fair values its private assets, dislocations from NAV may occur, especially during periods of volatility. The costs of accessing liquidity through private asset liquidity providers may balloon in volatile times. Overall, quoting these ETFs will be challenging for many market makers, but the ETF industry has a track record of overcoming similar challenges.