Private markets have become increasingly open to diversification-hungry individual investors.
The hunt for differentiated performance has become more difficult as equity and fixed income returns have become more correlated—this at a time when many investors are heavily exposed to those assets and the portfolio volatility that can come with them.
Private markets may be an option. Private market investments have historically been within the purview of institutions and ultra-wealthy individuals well-positioned for access, but innovation in investment structures has opened up the asset class to a broader cross-section of investors, increasing their practical potential as a foundational part of asset allocation.
At this point, exposure by individuals remains limited, with those investors representing only 16% of alternative fund assets, compared to their roughly 50% ownership of the world’s $275 trillion to $295 trillion in global assets1. However, this is changing and by next year, about 46% of high-net-worth investors are expected to have exposure to private markets, up from 29% in 20222.
Unfamiliarity and complexity have historically been stumbling blocks, and many investors remain skeptical of private markets. However, we believe that better understanding will help pave the way to increased exposure for individuals benefiting from these investment opportunities. We believe that the historical risk/return benefits of private markets isn’t just a talking point, but is directly related to the characteristics of the investments and in many cases their illiquidity. Private assets come in various flavors that could cater to specific investment goals and provide helpful diversification away from traditional investments. Finally, the structural enhancements described below have not only improved access but dealt with the illiquidity and return-pattern issues that may have inhibited some investors in the past.
Opportunity Beyond Public Markets
We believe that any discussion of private markets should explore the basic math that adds to their appeal. Simply put, the number of public companies has declined in recent decades, cutting off public investors from a large section of the economy. Although the market capitalization of public companies is far larger than for private companies, the vast majority of businesses overall are now private, with fewer than 15% of companies with revenues over $100 million publicly held1.
Companies often stay or go private because of the expense and scrutiny experienced in public markets, which can prove counterproductive in seeking to achieve long-term business goals. By nature, the introduction of private market assets to portfolios can add investment opportunity that is often very different from public market exposure.
Private markets are also relatively inefficient, which means that managers can often generate informational advantages. They typically enjoy more direct governance control, and, thus, have the potential to create value through strategic and operational improvements.
In terms of timing, managers often spend months sourcing and completing investments, and have various exit opportunities, including trade sales, sales to other private equity funds and initial public offerings, adding to their flexibility.
There are several key sectors within the private space, including the following:
- Buyouts occur when the manager purchases control of a company with the goal of generating value by professionalizing the business, improving the management of cash flows, and introducing strategic changes. Companies are often mature and expected to provide relatively steady returns. Debt levels are often elevated but serviceable from repeatable cash flows.
- Venture capital businesses are typically newer, often with rapidly growing revenues and negative cash flows. They usually require regular infusions of capital to expand into new markets or reach new customers. Given their added risk, funds are likely to include more holdings than buyout funds.
- Growth companies usually fall somewhere between buyouts and venture in terms of business age and size, with managers working alongside the founders to expand more rapidly.
- Special situations involve the restructuring of distressed companies.
- Private credit consists of privately negotiated loans to companies. Investors typically receive a higher yield than for similar publicly traded debt in exchange for a degree of illiquidity. Interest payments are made on a periodic basis, allowing returns to be generated earlier than with private equity investments.
Means of Access
How can investors gain access to such opportunities?
Primary funds are the typical private equity structure. They generally have a lifespan of about 10 years and a cash-flow pattern known as the J Curve, where investors make initial capital commitments and wait for the manager to put that capital to work in companies, before it is harvested and returned along with any proceeds. For diversification, investors often choose a fund-of-funds structure, which provides exposure to more companies through multiple primary-fund investments.
In co-investments, investors invest alongside a private equity manager directly in portfolio companies. This reduces so-called “blind-pool” risk because the investor already knows the companies involved and can conduct specific due diligence. Investors who are paying management fees on another commingled strategy typically obtain access to co-investments without a fee. Such investments allow the immediate use of capital rather than following the J Curve pattern noted above.
Secondaries are a useful strategy that can offer earlier distributions than primary funds, making them an attractive way into the asset class. Investors may seek to sell their holdings in the secondary marketplace for a variety of reasons—including to lock in returns, manage exposures and access liquidity. Over time, the secondary market has gradually expanded and matured to become a standard means to gain access to already seasoned private equity investments, often at a small discount. Secondaries can provide diversification by vintage year, manager and underlying portfolio company.
Historically, individuals have faced hurdles in accessing private equity due to investor qualification rules and high minimums, as well as long-term illiquidity and the J Curve.
However, as mentioned, new structural innovations have begun to mitigate these issues. For example, while traditional private funds typically require a net worth of $5 million, certain registered funds can be offered to investors with a net worth of $2.2 million, while investment minimums have also been reduced, sometimes to as low as $50,000.
The newer structures can also use the array of strategies above to help with illiquidity and mitigate the J Curve. For example, while primary investments traditionally served as the foundation of a portfolio, the increasing use of co-investments and secondaries, along with private credit, can help to both put money to work more quickly and generate income and return on capital in a shorter timeframe than many traditional funds.
The table below highlights the similarities and differences of the different structures.
Comparing Private Market Vehicles
Can provide access to multiple segments and managers provides diversification within a single SEC-registered vehicle. Fund structure can offer simplified tax reporting, and lower investment minimums and qualification requirements.
Traditional Structures/Limited Partnerships
Can provide access to multiple segments and managers provides diversification within a single SEC-registered vehicle. Fund structure can offer simplified tax reporting, and lower investment minimums and qualification requirements. Range of available approaches, with differing levels of diversification and customization. Depending on the strategy, often include a capital-call period prior to potential distributions (the “J Curve”), and require long-term investment commitments. Vehicles typically have high minimums and qualification levels, and involve more complex K-1 tax filings.
|‘Evergreen’ Fund||Commitment amount due upon closing with no capital calls and potentially improved liquidity through periodic repurchase offers.
No defined fund life; will consistently allocate to investments over time.
|‘Drawdown’ Fund||Typical private equity fund structure, including periodic capital calls and distributions with a defined fund life (typically 10 years).|
|Commingled/ Diversified Funds (e.g., funds of funds)||Diversification across managers and sectors through a single investment.
Regular commitment to ongoing fund vintages typically required to achieve vintage diversification.
Traditional cash flow patterns, with some funds providing additional flexibility.
The investor may have minimal control over the portfolio.
|Individual Funds||Private equity exposure through commitments to multiple individual funds.
Often in specific areas such as buyouts, venture, growth, secondaries, coinvest and private debt.
Provides extensive investor control, but requires high levels of capital, research and resources.
|Custom Account||Hybrid of commingled and individual funds.
Affords professional manager involvement in an overall private equity portfolio, with a degree of investor control.
Much higher capital allocation requirements.
Considering Private Markets
Private markets offer opportunities that may not be available in the public space. In our view, built-in advantages have contributed to attractive risk-adjusted returns, while distinct investment characteristics make them an effective diversifier. That said, the choice of adding private markets exposure may come down to the specific circumstances of the individual. Engaging with advisors is an important first step in assessing whether private equity may make sense as part of your diversified portfolio.
MUNICIPAL BASIS POINTS
1Source: Preqin, GlobalData, Bain, 2022.
2Source: Hamilton Lane, Barron’s, January 10, 2023.
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