Are you ready for the rise of private capital in retail portfolios?

The equity market landscape is shifting, and advisors need to be prepared for it. Public listings have slowed in recent years, both in Canada and around the globe. At the same time, private markets such as private equity and private debt are attracting growing interest as alternative sources of growth.

What was once the exclusive domain of institutional investors and pension funds is now increasingly open to retail investors. Private capital vehicles offer the promise of diversification and the potential for enhanced returns.

“Democratizing access to private capital for retail investors is an exciting innovation with the potential to unlock meaningful returns,” says Ian Tam, Director of Investment Research at Morningstar Canada.

Yet this development also brings a new layer of complexity, risk, and know-your-product implications for advisors.

“It demands rigorous oversight and careful due diligence from Canadian advisors,” says Tam.

Crucially, he says, that includes understanding the liquidity of each sleeve of the portfolio before an advisor can responsibly suggest a product.

Regulations already codify greater due diligence for more complex investments. Knowing what’s inside these products, as well as how they behave under different market conditions, is critical to making suitable recommendations and demonstrating the advisor’s value.

New structures are opening the door

The drivers of interest in private capital include the recent period of low interest rates, as well as the weaker performance from dividend stocks and bonds.

With many investors looking for a steady stream of income and ways to further diversify their portfolios Tam says that “the growth of alternative vehicles was magnified further by the dismal performance of the 60/40 portfolio in 2022, when both stocks and bonds saw simultaneous declines.

New structures are opening up access. In Canada, these include a single interval fund, a growing number of liquid alternatives that can allocate to private capital, and infrastructure products in an ETF wrapper.

The Ontario Securities Commission also recently wrapped up a public consultation around long-term funds, scoping interest from the market on a retail fund structure with less frequent redemptions. That mirrors products available in the UK. Investors can also access private markets through the exempt market. (Typically, though, that’s for accredited investors.)

In the U.S., the private capital trend is further along, especially in interval funds. At the end of 2024, this segment represented about US$80 billion in assets.

Even investors who haven’t actively sought out private markets may already have some exposure.

Based on Morningstar data, about 30% of balanced funds in Canada have some small sleeve of alternative investments (e.g., private capital, infrastructure, hedge funds, crypto) embedded in them. Furthermore, every working Canadian is already invested in private capital through the Canada Pension Plan.

“Advisors need to be keenly aware that these alternative asset sleeves exist in even the most plain-vanilla balanced funds,” says Tam. “They should be prepared to answer basic questions like how much exposure and what types of assets the investor is exposed to.”

Watch out for liquidity risks

For advisors who are used to traditional managed products like mutual funds and ETFs, Tam says it’s vital to understand the liquidity premium. “Are you getting compensated for having your money locked up?”

Liquidity is a major risk, raising considerations of whether there’s a match between an investment’s redemption terms and the client’s cash flow needs. Tam offers a simple example: “A client retires next year, needs a large amount of money, and is locked up for another 10 years in a private capital fund.”

A liquidity mismatch, where a client can’t get their money out when they need it, would be “catastrophic,” he says. “That’s the ultimate risk and a failure as an advisor.”

Private capital also brings valuation challenges. “It’s tough to understand the value of these assets because they don’t change hands often, unlike a stock or a bond. There’s no market price for them.”

While these alternative products can offer diversification, if you think about the underlying assets, Tam says advisors might take that with a grain of salt. “We don’t evaluate them frequently. They’re illiquid for a reason.”

The market keeps growing

Tam expects private market access to keep expanding. “With more and more retirees, there will be a demand for greater yield, and a demand for diversification if you believe that’s what it does.”

Canadian regulators are keeping an eye on the decline in IPOs and the ramifications for capital formation. We’ve seen measures like allowing public companies to raise an additional 20% of their market cap without filing a full prospectus. The limit has also been lifted on how much an individual can invest in an exempt product.

“Regulators are keenly aware of the need to enhance capital formation in Canada. One doorway might be broader exposure to private assets but with a very cautious approach,” says Tam.

As more retail-accessible structures emerge, the challenge will be balancing an openness to greater private market access with investor protection.

Advisor readiness means understanding both the opportunities and the constraints around private capital in retail portfolios. “The liquidity risk is a sticking point that precludes many investors from getting involved,” says Tam. “When they do, the trade-off must be worthwhile.”