Investing in Private Markets and Public Markets

Post the Global Financial Crisis (GFC) of 2008–2009, the subsequent decade witnessed favorable market conditions, including low interest rates, rising valuations, and increased risk appetite. These conditions led to private markets outperforming their public counterparts in terms of generating returns and attracting capital.

As per McKinsey, a global management consulting firm, the median net IRR for global private equity funds with vintage years from 2009 to 2019 averaged 20.1% from inception through late 2022. In contrast, the S&P 500 Index returned an annual average of 11.8% over roughly the same period.

Global private market fundraising reached an annual high of over USD1.35 trillion in 2021, approximately double the amount raised in 2007, the year prior to the GFC.

Institutional investors have increased their allocations to private market asset classes, such as private equity, debt, real estate, and infrastructure. Policymakers in Europe and North America have also facilitated private market access for smaller investors.

Variability in Private Market Returns

Private market returns exhibit a high degree of variability due to the specialized manager skills and broader range of investments and life cycle phases. Private equity returns are not only volatile over time but also much more variable among fund managers as compared to both public markets and other private market categories.

Manager Performance Differential

For the private equity funds with vintage years from 2009 to 2019 from inception through late 2022, the manager performance differential between the top (29.8%) and bottom (11.4%) quartiles was 18.4%. This implies that managers in the bottom quartile slightly underperformed the S&P 500 on average over the period. Other private asset classes, such as private debt, reflected smaller performance differences among managers.

Effects of Private Market Features on Risk and Return

1. Capital Commitment: Capital that is committed but not yet called is not yet invested in private market assets. Investors often hold these commitments in liquid public investments with lower expected returns.
2. Deployment: In the early years of capital drawdown, committed funds are contributed before any returns are realized while being assessed fees, resulting in negative periodic returns. General Partners (GPs) provide periodic fund valuations to investors. Prior to the distribution of returns, these valuations often include illiquid and unrealized capital gains that will only be received upon exit.
3. Return Distribution: Once returns reach the amount of capital contributed, the fund reaches an Internal Rate of Return (IRR) of zero. Over time, the IRR converges to the true compounded return at the end of its life. The combination of the long investment horizon and J-curve effects causes private market returns to be more reliant on price appreciation over the investment life cycle versus returns for public market investments, which are more likely to involve companies or assets that generate consistent, stable cash flow streams.

Private Market Strategies

Investors expect greater return in exchange for both the greater uncertainty and the illiquidity associated with private market strategies.

Private market debt and equity investments also provide investors access to a broader range of companies that expand the risk and return potential beyond available public investments.

For example, early-stage venture capital investments target companies with exponential growth potential in emerging industries.

These startup firms have a very high risk of failure but when successful also have a very high return potential.

The exclusion of such very small or pregrowth companies from public listings reduces the potential return but also the risk associated with public equities.

Venture capital investments in startup companies with little or no revenue and negative cash flow have a very high failure risk.

Risk and Return across Asset Classes

When making strategic allocations to private market asset classes, it is crucial to compare the relative risk and return of each investment type with its more standardized, liquid equivalent in the public markets. This comparison helps in understanding the potential benefits and drawbacks of private market investments.

Private market investments are those that are not listed on a public exchange. These investments are often characterized by a higher degree of risk and potential for return compared to their public market counterparts. The risk and return profile of private market investments can vary significantly depending on the specific asset class and investment strategy.

Equity

Public Equities vs Private Equity Funds

Public equities are associated with larger, mature companies with stable cash flows.

Private equity funds typically invest in early-stage venture capital or growth equity opportunities, as well as mature buyout opportunities.

The investment thesis of mature buyout opportunities involves purchasing a controlling stake in a firm to improve operations and target a higher exit price.

Growth Equity

Growth equity refers to a minority investment in a young company with a business model and rising revenue. These companies are seeking to rapidly scale their operations.

Private Equity Strategies

Private equity strategies aim to achieve high risk-adjusted returns and portfolio diversification relative to public equities. This is achieved by targeting earlier company life cycle phases than those prevalent among listed companies and using high leverage over a restructuring period in the case of Leveraged Buyouts (LBOs).

Early-stage Private Investments

Early-stage private investments are concentrated in emerging industries, such as information technology or biotechnology, or have new business models. The growth of these companies is often fueled by innovation rather than the economic cycle.

Private Market Investments

Although private market investments may outperform listed equities in some periods, linkages between these markets remain. These linkages are in the form of entry and exit prices, market-based valuation multiples, and the cost of debt.

Debt

Public Fixed-Income Investments

These are primarily non-callable sovereign or investment-grade bonds. They are usually issued by mature issuers with stable cash flows. They carry little default risk.

Private Debt

Private debt may involve early-stage startup borrowers with greater default risk. It can be sourced from non-bank lenders in the form of direct lending. It may involve subordinated mezzanine debt with equity-like or other contingency features. Private debt return and risk dynamics often diverge from those of public debt. The divergence is due to different issuer life cycle stages, default risk, distinctive debt features, and a high degree of illiquidity.

Real Estate

Real Estate is a significant area of investment that can be divided into two main categories: publicly traded securities and private investments. Publicly traded securities are often associated with real estate investment trusts (REITs). These trusts directly own and operate income-producing properties, which usually generate relatively stable cash flows. This stability is a key feature of publicly traded securities in real estate.

On the other hand, private investments in real estate typically involve major renovations or new development projects. These investments have more equity-like features, including an investment cycle characterized by negative cash flows and less certain future income prospects. This uncertainty and the potential for negative cash flows make private investments riskier than publicly traded securities.

Investors in private real estate funds typically expect greater returns to compensate for the longer investment period, greater market risk, and illiquidity associated with these strategies. Additionally, private real estate funds generally have a higher idiosyncratic risk compared to more diversified REITs. This higher risk is due to the specific characteristics and circumstances of the individual properties and projects in which the funds invest.

Infrastructure

Infrastructure investments can be made through publicly traded corporations or private investments. Publicly traded corporations involved in infrastructure are usually mature, well-established companies. They have a pipeline of projects at various stages, which generate consistent cash flows. On the other hand, private infrastructure investments often involve greenfield investments. These are new, “to-be-built” projects that have a long investment period and a high degree of execution risk.

Private investors expect higher compensation for taking on these risks. However, they may also realize portfolio diversification benefits during a project’s operating phase. This is because the cash flows from these projects are less correlated with the economic cycle.

Another private market strategy that does not have a direct counterpart in the public market is special situations. These investments aim to generate returns by investing in stressed, distressed, or event-driven opportunities. These opportunities can involve either public securities or private assets. The prevalence of greater financial distress during an economic downturn provides the opportunity to generate high returns using these strategies, even under adverse market conditions.

Asset Allocation with Private Markets

Private market strategies involve more complex investments and structures compared to public markets. Limited partners need to plan and stage their private investments carefully and engage with General Partners (GPs) regularly to maximize the risk-adjusted return potential of a private market allocation.

Investors need to commit uncalled capital for an extended period and hold investments over a multiyear investment cycle. The distribution size and timing are uncertain, which necessitates enhanced liquidity planning. Investors must establish a plan for investing committed, uncalled capital and incorporate this plan into portfolio return expectations.

Due to limited pricing transparency and high degree of illiquidity over an investment holding period, limited partners must consider the lagged performance reporting for these assets in their governance framework. They also need to maintain sufficient portfolio liquidity to minimize the potential of incurring secondary market costs associated with early liquidation.

As investors expand beyond an initial allocation to private markets, it is crucial to consider a pacing strategy. This involves committing a certain proportion of assets to an asset class or strategy each period, regardless of market performance. In some cases, limited partners may have limited discretion to accelerate or decelerate the pace of investment depending on relative market conditions. In situations where specific vintage years or strategies are difficult to access, the investor must balance the diversification benefit with the cost.

It is important to maintain and develop relationships with GPs as private capital commitments are deployed and distributions begin. This allows for a consistent proportion of uncommitted capital to be rolled into new funds each period.

Questions

Question 1

The Global Financial Crisis (GFC) of 2008–2009 had a significant impact on the financial markets. In the subsequent decade, certain market conditions prevailed that led to a shift in performance between private and public markets. Considering the low-interest rates, rising valuations, and increased risk appetite, which market outperformed in terms of generating returns and attracting capital?

1. Public markets
2. Private markets
3. Both performed equally

Answer B is correct.

Post the Global Financial Crisis (GFC) of 2008–2009, private markets outperformed in terms of generating returns and attracting capital. The low-interest rates environment made borrowing cheaper, thereby encouraging investments in private markets. Rising valuations, particularly in the technology sector, provided lucrative investment opportunities in private markets. Additionally, the increased risk appetite of investors, driven by the search for higher returns in a low-yield environment, led to a surge in investments in private markets. Private equity, venture capital, and private debt funds saw significant inflows during this period. The private markets also benefited from the trend of companies staying private for longer, thereby providing more opportunities for private investors to participate in their growth. Therefore, considering the market conditions post-GFC, private markets outperformed public markets in terms of generating returns and attracting capital.

A is incorrect. While public markets also saw a recovery post-GFC, they did not outperform private markets in terms of generating returns and attracting capital. The low-interest rates environment led to a surge in investments in riskier assets, but the returns in public markets were not as high as in private markets. Furthermore, the trend of companies staying private for longer reduced the opportunities for public market investors.

C is incorrect. Both markets did not perform equally. While both markets saw a recovery post-GFC, private markets outperformed public markets in terms of generating returns and attracting capital. The market conditions post-GFC, including low-interest rates, rising valuations, and increased risk appetite, were more favorable for private markets.

Question 2

Once returns in a private market fund reach the amount of capital contributed, the fund reaches an Internal Rate of Return (IRR) of zero. Over time, the IRR converges to the true compounded return at the end of its life. This combination of a long investment horizon and J-curve effects makes private market returns more reliant on price appreciation over the investment life cycle. How does this compare to returns for public market investments?

1. Public market investments also rely heavily on price appreciation over the investment life cycle.
2. Public market investments rely more on companies or assets that generate consistent, stable cash flow streams.
3. Public market investments do not rely on either price appreciation or consistent cash flow streams.

Answer B is correct.

Public market investments rely more on companies or assets that generate consistent, stable cash flow streams. Unlike private market investments, public market investments are not as heavily reliant on price appreciation over the investment life cycle. Instead, they are more dependent on the consistent and stable cash flows generated by the companies or assets in which they are invested. This is because public market investments are typically more liquid and can be bought and sold more easily than private market investments. As a result, investors in public markets can realize returns more quickly through dividends or interest payments rather than having to wait for the investment to appreciate in value over a long period of time. Furthermore, the value of public market investments is often more closely tied to the financial performance of the underlying companies or assets, which is typically reflected in their cash flows. Therefore, the ability of these companies or assets to generate consistent, stable cash flows is a key factor in determining the returns on public market investments.

A is incorrect. While price appreciation can contribute to the returns on public market investments, it is not the primary source of returns as it is in private market investments. Public market investments are more reliant on the cash flows generated by the underlying companies or assets, which can be realized more quickly due to the liquidity of these markets.

C is incorrect. Public market investments do rely on both price appreciation and consistent cash flow streams. However, as explained above, they are more reliant on the latter. This is not to say that price appreciation is not important in public markets but rather that it is not the primary source of returns as it is in private markets.

Glossary

• Global Financial Crisis (GFC): A worldwide period of economic difficulty experienced by markets and consumers.
• Internal Rate of Return (IRR): A metric used in capital budgeting to estimate the profitability of potential investments.
• General Partners (GPs): A partner whose liability is not limited. All partners are liable jointly and severally for all the partnership’s debts and obligations.
• Real Estate Investment Trusts (REITs): A company that owns, operates, or finances income-generating real estate.
• Greenfield Investments: A type of foreign direct investment (FDI) where a parent company builds its operations in a foreign country from the ground up.

Private Markets Pathway Volume 1: Learning Module 1: Private Investments and Structures; LOS 1(d): Compare the risk and return of investing in private markets and public markets as part of a strategic asset allocation.