Private markets are well known as a means to diversify and seek returns distinct from those available in public markets. But what does it take to succeed in this area, and what’s our approach to generating opportunity?

Potential Benefits of Private Markets Investments

Before getting into “what works,” it’s helpful to understand the broad case for private markets investments. As we’ve often explained to clients, it includes the growing number of private companies available for investment relative to public companies, and key advantages enjoyed by managers in the private space, such as better information flow, greater control of portfolio companies, less pressure for near-term results, and more flexibility in the timing of entries into and exits from portfolio positions.

Also crucial is the diverse array of strategies available, from venture capital to buyout funds to secondary investments consisting of mature investments already in the marketplace. Add to that the multiple structures in which to invest that cater to client needs—from high-minimum primary funds with gradual capital calls to more accessible semi-liquid registered funds with lower minimums and single capital calls.

From a portfolio perspective, private markets investments can serve an array of purposes: Private equity can be a source of capital appreciation potential, private credit can offer a new source of total return and income, and private real estate can provide diversification and an inflation hedge. The levels of potential exposure among these areas and in specific funds depend on individual circumstances and priorities, as well as qualification thresholds. A useful summary of the basics is available as part of our Thematic Currents series.

Fundamentals, Diversification

Beyond the broad concepts, what constitutes an effective approach to generating risk-adjusted return from private markets investments? We think the answer is to combine a focus on fundamentals and prudent risk management.

At Neuberger Berman, we look to build diversified portfolios across company, sector, geography and manager. As part of this process, we seek to invest in quality businesses alongside top-tier managers in their core areas of expertise. We look to be a provider of valuable capital and a partner to other private markets firms to enhance their efforts and to also generate robust deal flow for our clients; this helps us to be highly selective and create portfolios of private market investments that we believe reflect attractive risk-adjusted opportunities. We can do this through primary investments into the private markets managers’ funds; equity co-investments, credit or other capital solutions directly for their portfolio companies; and by offering secondary liquidity solutions.

We believe all of the above gives us unique access, deal flow, information and a due diligence advantage in an asset class that is notoriously difficult to analyze and access, particularly when it comes to top-tier managers. We benefit from relationships developed over three decades in the business, as well as our large, experienced team, many of whom have been here for years.

Similar to the industry at large, we avoid the old practice of “financial engineering”—for example, purchasing mature manufacturing businesses, loading the balance sheet up with financial leverage, paying down the leverage and exiting at an increased multiple. Today, deals typically contain much less debt, which means that skill in running and creating value within the business becomes more important. We also seek to avoid cyclical businesses in order to minimize the impact of market cycles: Given longer investment timeframes, it is more difficult to time investments in private than public investing.

Importantly, our process is highly selective, involving extensive research on investment managers, including their track records and how they were achieved, their success in executing value-creation plans and more. We emphasize owning market-leading companies in industries with secular growth tailwinds (e.g., software, technology or business services). The companies often have robust business models, healthy profit margins and strong topline growth that can persist through economic cycles.

The Current Environment

In our view, such advantages may be particularly important in today’s environment, which has changed dramatically in the wake of tighter financial conditions and a more mixed fundamental picture. We believe differences among companies are likely to be accentuated given structurally higher inflation, current elevated interest rates and likely slower growth.

This means that two past sources of private markets returns may be harder to achieve: the use of cash flow to pay down debt and increase equity, and relying on potential increases in valuation multiples over time (given already full valuation levels). We feel this puts the focus more squarely on investment selectivity and the array of levers that managers can apply to seek positive results, such as: management training and incentives to enhance alignment with investor interests, capital and resources to support growth and operational improvement, and financing of strategic mergers and acquisitions.

Interestingly, although deal volume in the private equity market has been sluggish, our platform has experienced increased deal flow as firms have looked for liquidity and financing. Moreover, we are finding particular opportunity within a few general areas: general partner (GP)-led secondaries, co-investments, private debt and capital solutions opportunities.

Given the outperformance of private markets in recent years¹ and a slowdown in distributions from existing investments, many institutional investors are looking for liquidity to redeploy excess exposures to other areas. For their part, the managers, or GPs, may want to stay invested in what they consider still-promising holdings while attracting needed capital. GP-led secondary offerings can allow both to happen while opening a new door for other investors. We’ve also observed that co-investments, or direct investments in companies alongside private equity managers, have become attractive amid scarce capital and reduced competition. Private debt, meanwhile, has displaced banks and other lenders in providing valuable capital to businesses, and continues to offer compelling yields in exchange for a degree of illiquidity. Finally, capital solutions provide customized structures for GPs and their portfolio companies.

Integration Into Portfolios

In considering private equity or debt for portfolios, a key issue is liquidity—both as to the timeframe of the investment and the pattern of capital calls and distributions found in more traditional vehicles. In terms of risk, it can make sense to align new exposures with analogous public areas—private equity with public equity and private debt with public fixed income. Overall, we often look to private markets to represent about 10 – 15% of a moderately aggressive portfolio, but specifics may vary dramatically.

Stepping back, we also believe a decision to invest should entail selectivity. Results in this universe can vary significantly, so aligning yourself with an experienced, prudent manager can help potential for successful outcomes. Your NB Private Wealth team can help you consider the issues.