Schrödinger’s Cathouse

A Look Inside Private Assets

There is a popular conundrum in quantum physics that defies our everyday intuition. First proposed by Edwin Schrödinger, a pioneer in the foundation of the field, it was the result of certain absurdities that appeared when the theory was applied to everyday experience.

Quantum mechanics held that at the most fundamental, microscopic scales, it was impossible to distinguish between particles and waves and was therefore futile to try to pinpoint the exact location of the building blocks of physical reality.

One popular school of thought held that the location of a quantum wave/particle could only be resolved by the act of looking at it, in which case it would register as a discreet particle where your instruments were focused. Light waves passing through a detector would suddenly appear as discreet photons once they hit the detector. Otherwise, they existed as waves that could not be localized with certainty.

The idea that things could be in several places at once but would appear in one place when observed was extremely counter-intuitive, particularly if the quantum effects were extended to everyday phenomena. Illustrative of this difficulty was Edwin Schrödinger’s thought experiment, in which he envisioned a cat inside a sealed box that contained a radioactive atom. When the atom decayed, the resulting reaction would immediately kill the cat. Looking inside the box at any point was also fatal. When the odds were 50-50 that the fatal decay had taken place, one was forced, by the dictates of quantum uncertainty, to assume that the cat was both dead and alive.

Aside from the difficulty that this posed for ordering cat food, the concept was a clear affront to common sense. The counterintuitive principles of duality and indefinite location were widely accepted and confirmed at quantum scales. Schrödinger did not take issue with that premise. The paradoxical case of the cat was only meant as an illustration of the divide that exists between real, accepted quantum uncertainty and the macroscopic world with which we are familiar, where quantum phenomena are completely hidden in familiar, classical structures. A cat, or any similarly large object, cannot be isolated in a closed system like an atom or other quantum scale entity. The cat is always being “observed” by interactions with the environment, which act to constantly resolve it to one physical state and one place at a time.

Quantum uncertainty of the type that prevails at microstates is a reasonable metaphor for the condition of assets inside of an opaque, private fund. The valuations and fundamental dynamics can be construed as being in many places at once, depending on the imagination of the observer. The same loan or equity holding can have very different valuations reported by different managers within their respective boxes. It is only when someone from outside the system disturbs the equilibrium by looking inside the fund that things resolve to a more definite value.

In contrast with Schrödinger’s cat, which is not, in reality, changed by the act of looking inside its box, a look inside an increasing number of private funds often uncovers positions that were assumed alive but are, under neutral observation, revealed to be lifeless or nearly so.

Recent episodes involving Renovo, Tricolor Holdings, Thrasio and First Brands all revealed processes where loans were held within private credit funds at values between 80 and 97 percent of face value. In each case the bonds were marked down between 50 and 90% almost instantaneously as insolvency was revealed.

This brings us to the very broad issue of risk in private asset funds. This is a topic about which we will have a great deal more to say in coming commentary. We intend to look closely at the academic theory underlying the current rationale for including private assets in traditionally liquid portfolios and the unique avenues of due diligence that should be undertaken by investors and advisors faced with limited and conflicted sources of data.

Two major risks inhere at the structural levels that allow access to passive investment in private assets. Opacity and illiquidity are distinct features of funds that hold private assets. Both give rise to a series of derivative risks of which prospective investors need to be aware. Neither one can be adequately evaluated by the metrics of volatility, variance, correlation or other aspects of modern portfolio theory that are at least partially applicable to liquid, publicly traded vehicles and assets.

Investors in funds where independent information regarding performance, valuation and underlying business dynamics of the fund’s main holdings are counting entirely on the skills and integrity of the manager. This is particularly true when the structural lack of market liquidity does not allow an investor to easily retreat from a commitment if events undermine confidence in the management process.

Manager selection becomes the primary determinant of investors’ outcomes in private funds. This point was perfectly expressed by David Swensen in 2000, as follows:

“In fact, only top-quartile or top decile funds produce returns sufficient to compensate for private equity’s greater illiquidity and higher risk. In the absence of truly superior selection skills (or extraordinary luck), investors should stay far, far away from private equity investments”.

This observation by someone who was perhaps the single most successful institutional practitioner of allocation to non-traditional, alternative fund structures undermines the oft promoted concept that diversified exposure to a wide array of managers is an appropriate strategy for retail investors. Diversification is a powerful avenue for most passive investors in liquid markets, who aim for exposure to the broad forces driving capital asset returns. The incremental value that might exist in adding private assets to a traditional, liquid portfolio, is wholly dependent on active, managerial alpha. There is no inherent characteristic in private markets that empirically or conceptually suggests the likelihood of superior risk adjusted returns across the broad category.

This presents a thorny path for prospective investors or advisors. Either concentrate holdings with a few managers deemed to be exceptional, thereby accepting idiosyncratic risks without the detailed data to justify the decision or accept a broad, indexed exposure to the category, which has been shown to consistently fall short on a risk/return basis. When the broad exposure is obtained through funds of funds that comprise thousands of individual companies in the engine room from which returns flow, the problems are made more severe by an additional layer of fees and a second liquidity gate. A similar issue arises in private credit when the portfolio includes a meaningful proportion of credit derivatives (pools of loans or bonds that have been divided by a separate manager into tranches of differing seniority). This arrangement intensifies information shortfalls and idiosyncratic manager-specific risks.

In the final analysis, the only means of understanding what is happening inside the box is through comparison. Managers’ tendencies and general approaches can be roughly inferred by comparisons of terms, fees, policies and prices at which a widely held assets are valued by an assortment of managers. Managers displaying the most aggressive tendencies in terms, conditions and valuation can be ferreted out.