The remarkable performance of private markets (private equity, private credit, infrastructure, real estate, venture) over the past decade spurred rapid growth and large institutional allocations.

The post pandemic surge in inflation and interest rates has since raised input costs and debt burdens for portfolio companies while reducing private equity valuations, performance, fundraising and exits. As pension funds and retail investors gain exposure to private markets, governance risks have intensified amid leverage and long-term commitments.

This article examines the ethical challenges in private markets, including conflicts of interest, valuations, illiquidity, hidden fees and asymmetric information. In such opaque markets, ethics and strong governance serve as essential substitutes for transparency. We draw on findings from Private Markets: Governance Issues Rise to the Fore by Stephen Deane, CFA, and Continuation Funds: Ethics in Private Markets, Part I by Stephen Deane and Ken Robinson, CFA, CIPM.

Incentive alignment and conflicts of interest

Conflicts between GPs and LPs

General partners’ (GPs) access to asymmetric information provides them with a bargaining advantage over institutional limited partners (LPs).¹ Negotiations are often conducted under nondisclosure clauses. In bilateral negotiations, GPs and their outside law firms compile substantial data on limited partnership agreements (LPAs). When investors seek to share information or negotiate better terms, the GP’s counsel may accuse investors of collusion, leading the LP to limit or waive the GP’s fiduciary duties. The GP’s legal expenses are charged to the fund, meaning LPs pay for both their own and the GPs’ legal fees.

LPA contractual terms, a joint effort between the fund’s GP and LP, establish a governance framework and address potential conflicts of interest. However, they are often criticized for poorly defined, vague terms that grant GPs excessive flexibility and hinder effective LP oversight (e.g., broad characterization of fees and expenses and lack of clarity around valuation procedures, investment strategies and conflict-mitigation protocols). Therefore, large investors may negotiate privileged terms through side letters that supersede the LPA.

The limited partner advisory committee (LPAC) is another governance mechanism, composed of select LPs. The U.S. Securities and Exchange Commission (SEC) has questioned the effectiveness of LPACs, noting that they may lack independence, authority and accountability. Because LPAC members owe no fiduciary duty to the fund or other investors, their involvement can create additional conflicts of interest. Strengthening LPACs requires clearer obligations, greater independence and third-party validation in high-conflict situations.

Because LPAC members owe no fiduciary duty to the fund or other investors, their involvement can create additional conflicts of interest. Strengthening LPACs requires clearer obligations, greater independence and third-party validation in high-conflict situations.

Conflicts between the LPs that invest in private funds

Unequal access to information, costs and contract terms are defining features of private markets. Larger or more sophisticated LPs seek preferential terms such as reduced expenses, co-investment opportunities, separately managed accounts (SMAs) and exclusive side deals. Co-investments and SMAs often reduce or eliminate fees charged to investors in the main fund. These individually negotiated side letters and privileges create conflicts of interest among LPs.

Industry practices such as most-favoured-nation (MFN) status could partly mitigate the impact of exclusive side letters. While MFN status entitles investors to see the terms of investments with equal or lower capital commitments, it does not provide them with access to the terms of investments with greater capital commitments.

Conflicts between private equity and private credit funds controlled by the same parent

When a portfolio company receives investments from both private equity and private credit funds owned by the same parent sponsor, irreconcilable conflicts of interest arise in the event of financial distress. Private equity firms might pressure private credit funds to extend debt payment deadlines, amend covenant terms and show forbearance to salvage private equity investments in the company. While this may delay bankruptcy, it can destroy value for the credit fund. Mitigating conflicts between private equity and private credit funds under common ownership requires structural separation and independent decision-making, particularly in distressed scenarios.

Fees and expenses

Self-dealing and hidden fees are among the key issues in private markets, as GPs may structure expenses to the detriment of LPs and their returns. This includes fees paid to affiliates who provide services to portfolio companies. These charges are passed with limited disclosure. Because these consultants are presented as full-time members of the adviser’s team, LPs often remain unaware of costs beyond the management fee and carried interest. Meanwhile, advisers gain marketing benefits by showcasing high-profile operators without bearing their full costs. Other problematic practices include shifting expenses to LPs mid-fund, after fundraising and terminating employees only to rehire them as consultants.

Governance measures could include hard-coded definitions and capped fees, mandatory offsets, disclosures, active LPAC oversight, standardized side letters and locked expense allocations.

Valuation integrity

Accuracy and timeliness of valuation and the incentives behind valuation impact the credibility, efficiency and integrity of private markets. Inconsistencies with respect to valuations could include:

• Using valuation methodologies different from those disclosed to investors
• Changing valuation methodologies to inflate struggling investments
• Cherry-picking comparable companies or precedent transactions to arrive at a target price
• Misrepresenting adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA)
• Inflated internal rates of return (IRR) using subscription financing or net-asset-value loans

Valuations are typically performed internally by the fund manager, often with input from third-party valuation firms or auditors. These third parties rely heavily on GP-provided assumptions. Internal models and valuation methodologies of fund managers are not standardized, and unlike public markets, there are no liquid secondary markets for private assets to base valuations on; valuations often take place annually or quarterly. Thus, private market valuations appear smoother and less volatile (volatility laundering) than public market prices, and they are a misleading indicator of asset value.

Private market valuations appear smoother and less volatile (volatility laundering) than public market prices, and they are a misleading indicator of asset value.

Institutional LPs use interim valuations to measure and periodically rebalance their asset allocation. During market downturns, stale prices could misrepresent private market asset values, leading to them being under or overweight relative to public market assets (the denominator effect). This could cause pension fund allocation to deviate from target allocation, leading to erroneous rebalancing. Flawed rebalancing could lead to elevated risk levels.

Additionally, some GPs inflate fund valuations during fundraising, only to write them down after the fact. When investors use interim valuations to determine future cash flows and reinvestment needs, the quality of valuation directly impacts the operating performance of investor institutions and future returns. A compromised valuation leads to misallocated funds and higher operational costs.

Governance measures to address these concerns include independent valuation oversight through third-party reviews, enhanced disclosure of methodologies and assumptions and audit-backed validation through back-testing.

Retail access and evergreen funds

Conflicts of interest, asymmetric information, illiquidity, long investment horizons and self-serving actions pose significant risk to retail investors. Evergreen retail funds, a type of alternative mutual fund, have emerged as a major player in the secondaries markets, providing retail investors with immediate capital deployment, no capital call requirements and limited liquidity. Structural safeguards, clearer disclosures and independent oversight could mitigate risks to retail investors.

Secondary transactions and continuation funds

Demand for liquidity, coupled with the need for additional time to execute value-creation plans, is driving the increase in adviser-led and investor-initiated secondary transactions. GP-led secondary offerings such as continuation vehicles acquire legacy fund assets and transfer them into portfolios managed by the same GP. This allows GPs to extend holding periods and seek higher future exit values. Such secondary transactions not only provide liquidity to LPs who do not roll over their positions, but also benefit legacy investors who invest in the new fund. Investors in secondaries face the risk of asymmetrical information, adverse selection and heightened conflicts of interest for GPs and LPs.

Regulation

In August 2023, the SEC adopted a series of new rules with respect to adviser conduct focused on the required disclosures and investor consent requirements. The new rules require private fund advisers to provide quarterly statements that include information about the private fund’s performance, fees and expenses; obtain an annual financial statement independent audit for each private fund; and obtain a fairness or valuation opinion in connection with an adviser-led secondary transaction. Under these regulations, advisers can offer preferential rights to investors only if they disclose the terms in writing to current and prospective investors. These disclosures include material economic terms, liquidity rights, fee breaks and co-investment rights.

Any regulatory, examination or compliance fees and expenses can be allocated to the private fund only if disclosed to investors. The regulation of private equity markets by the SEC has not established standardization across valuation methodologies.

Governance at the forefront

Private markets create distinct ethical risks: conflicts of interest, limited transparency, illiquidity, longer lock-ups, valuation discretion, suitability and sponsor relationships. Ethics can serve as a substitute for transparency in markets where discipline is weaker. The ethical principles are embedded in sound governance practices, compliance oversight and clear disclosures. The successful implementation of ethical conduct through strong governance is foundational for investor trust and long-term industry credibility.

¹ Limited partner (LP) investors are passive partners who commit capital but don’t manage the fund. General partners (GPs) are fund managers and advisers who make the investment decisions and are responsible for day-to-day fund’s operations.

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Sanaz Danielle Fotoohi, CFA, AFM, MBA, is a volunteer member of CFA Society Toronto’s Strategic Content Committee and Editorial Committee and a contributor to The Analyst.