Investing in Private Markets: The Advantages and Disadvantages
Sloan Smith, MBA, CAIA, CPWA® | Principal
Over the last twenty years, the growth of private market investing has been substantial. The exposure of private market asset classes in institutional portfolios has grown from around six percent in 1999 to over 20% at the end of 2019 (1). It is important to note that the primary private market asset classes are private equity, private debt, private infrastructure, direct real estate, and real assets (i.e. farmland and timber). A key driver behind this allocation increase was the low interest rate environment that followed the global financial crisis where investors were searching for higher returns outside of fixed income and equities.
Also, the strong returns in private markets are appealing considering some asset classes, such as private equity, have outperformed their public market equivalents (i.e. MSCI All Country World Index) over numerous time frames. However, there are some setbacks to investing in private markets, especially to some high net worth individuals, who are trying to get exposure to this space and may not understand the investment and fee structures. Ultimately, private market interest has increased tremendously, yet it is still important to determine whether it has a role in portfolios going forward.
The Advantages of Private Market Investing
1. Diversification
Incorporating private market asset classes into a traditional equity and bond portfolio provides exposure to unique opportunities (i.e. private equity, private debt, real assets) relative to the greater public marketplace. Also, the low correlation and beta components are beneficial, especially during times of market volatility. For example, real asset classes such a farmland and timber have a correlation and beta of close to 0.1 relative to public equities and bonds while offering a very different risk and return profile.
2. Lower Volatility
Private market investments are more illiquid relative to equities and fixed income and usually provide delayed valuations. However, after unsmoothing returns, it has been found that private market investments can assist during difficult market periods and potentially minimize total portfolio volatility. For example, private equity investments declined in value by an average of 34 percent during the dot-com bubble and the global financial crisis while global equities fell closer to 40% (2). Also, during more recent recoveries, private equity has performed in-line or better than public market equity indices.
3. Long-term Focus
Unlike public companies and markets, which tend to concentrate heavily on the short-term, private markets have a greater focus on the long-term. Private market portfolio managers (i.e. general partners) have control and discretion over when to exit an investment. When exit multiples are unattractive, they have the ability to hold onto an asset until the selling price is more appealing. Also, if multiples and demand are high, they can potentially accelerate an exit out of a particular company. Ultimately, having a long-term time horizon is advantageous considering private investment strategies are not expected to immediately react during a market downturn.
The Disadvantages of Private Market Investing
1. Access to quality managers
For some investors, it is difficult to access top- tier investment talent in the private market space. A majority of the best performing funds require high minimum investments and may only be open to certain clientele (i.e. large endowments or foundations). Also, the difference between a top-quartile manager relative to a bottom-quartile manager is drastic in private markets relative to public markets. For example, over the last ten years, the annualized performance difference between a top quartile and bottom quartile United States and European Private Equity fund is approximately 19%, while the annualized performance difference between a top quartile and bottom quartile US and European Equity fund is only two percent. (3)
2. Tax reporting and liquidity
These are two items that provide significant challenges for high-net-worth individuals. Many high-net-worth individuals are not in favor of holding a long-term asset that does not offer a liquidity provision. Also, handling multiple K-1s is a burden from a tax perspective. Ultimately, some high-net-worth individuals have decided to avoid private markets completely because of these issues. However, some new investment vehicles have surfaced that are trying to solve these problems. Examples include mutual funds, interval funds, and registered investment companies (RICs).
3. Fees
The fee structure for private investments is expensive as most funds charge, not only a management fee, but also an incentive/performance fee. The management fees tend to range from 1-2 percent while incentive fees are usually as high as 20 percent. The incentive fees in private market strategies usually do not get initiated until a return target or hurdle has been satisfied. For example, a fund may have to generate an eight percent annualized return before charging an incentive fee. However, public market fund fees are significantly less expensive, which makes asset classes within the private markets less appealing.
The interest in private markets continues to develop. Recently, higher returns and lower observed volatility has caught the attention of larger institutional investors around the world. Also, private markets remain relatively small, making up less than 10 percent of global markets, which means that additional capital can flow into the space without hindering returns. (4) However, there remain some issues that could negatively impact portfolios. It is important to review these potential obstacles with your clients before pursuing an allocation. Ultimately, a formal discussion focused on long-term objectives such as expected return and downside risk will play a key role in determining whether a private market investment is an optimal decision going forward.
Figure 1
2019 Estimated Percent Allocation to Private Markets among large institutions (5)
Figure 2
Performance of Private Markets during Bear and Bull Markets (6)
References:
1 McKinsey & Company. 2020. A new decade for private markets. McKinsey Global Private Markets Review 2020.
2 Keck, Thomas P., Venne, Michael M., Ment, Jason, Yau, Christable “Investing in Private Markets: A Guide for High-Net-Worth Individuals”
3 Ibid
4 Ibid
5 “Everyone now believes that private markets are better than public ones” https://www.economist.com/finance-and-economics/2020/01/30/everyone-now-believes-that-private-markets-are-better-than-public-ones
6 Keck, Thomas P., Venne, Michael M., Ment, Jason, Yau, Christable “Investing in Private Markets: A Guide for High-Net-Worth Individuals”