How will growth in private markets affect investors?
As private markets grow, public markets are shrinking. Although this trend has been underway for many years, it has been more widely discussed recently.
Over time, the performance of active investments in public markets has often been disappointing. With passive investing offering significant savings on fees, more investors are seeking out active management in relatively expensive private investments. High public-equity valuations and low bond returns are also prompting investors to look for different forms of diversification, including private markets.
At the same time, the number of publicly listed companies is falling. The reasons for this include the cost of a public listing, an arguably burdensome regulatory environment and the ready availability of private capital. Between 1996 and 2018, the number of publicly traded US companies fell by 45%, from 8,090 to 4,397. Share buybacks have also reduced the aggregate amount of publicly traded shares.
Another factor in the decline of public markets is large firms’ voracious appetite for buying smaller ones. This means that fewer companies are going public. Between them, Google, Facebook, Apple and Amazon have bought more than 500 companies in the last two decades.
Companies can stay private for longer, which means public markets present fewer opportunities to invest in companies during their periods of highest growth.
The shrinking of public markets has important implications. During the last few years, the private funding available to companies at the later growth stage has grown significantly. Companies can stay private for longer, which means public markets present fewer opportunities to invest in companies during their periods of highest growth. Public market investments have become increasingly transparent, accessible and cheap, but private markets often don't share the same characteristics. The wave of private capital thus appears to be eroding the so-called democratization of investing.
Growth in private credit
Given both the success and limited supply of private-equity (PE) investments, investors have also been allocating capital to private lending. Many alternative investment managers have embraced this opportunity. And with the US Federal Reserve cutting interest rates, private lending has become even more attractive to yield-starved investors.
Market-based lenders are yet to be tested by a recession, however. Accordingly, investors’ assumptions about risk, reward and correlation are merely working hypotheses and are likely to be subject to change. While a bank typically has multiple lines of business with a customer, a marketplace lender might have just one. This means that banks have more ways to make a borrower pay if something goes wrong with a loan. Also, banks have teams of professionals whose job it is to work out non-performing loans. Marketplace lenders don't. Although they may be able to redeploy staff from lending teams, this might not work well in practice.
As marketplace lenders are well supported by regulators and policymakers and have generally used less leverage than the banks did in the past, it seems unlikely that they will exacerbate a recession when it finally arrives. But their light-touch environment is very different from that in which the banks operate. During the next recession, the pendulum may swing back.
Allocations and expectations
Private-market returns may be attractive. But they are still likely to fall short of investors’ needs. Although the move towards private markets could allow investors to increase their portfolios' overall returns, many may not have enough invested to meet their portfolio's return target.
As an example, our current long-term forecasts for PE returns are around 7%, rising to around 12% if you can select the top-quartile managers. This return profile may be worth pursuing, being far in excess of our public-market forecasts. But it still falls well shy of the return necessary, for certain pension fund investors, to make up the shortfall left by their public-market investments.
Perhaps the most likely outcome is simply that scheme members will have to reduce their pension expectations – or that scheme sponsors will have to increase their contributions. Governments may also have to provide supplemental pension benefits to those most affected.
The challenge of increasing allocations
Although many investors aspire to allocate an increasing proportion of capital to alternative investments, including private markets, these investable markets are still a fraction of the size of the public markets. For most investors, achieving an average allocation of even 10% seems aspirational at this point – there just isn't the capacity.
It’s also difficult to replicate on a large scale, the strategies that generate returns above those of public markets. Looking at the larger PE managers, for example, average returns are lower. As PE has received more investment, the excess returns it generates have declined. The same phenomenon is occurring in venture capital, private debt, infrastructure, real estate and other asset classes.
Will the wheel turn again?
At present, only sophisticated investors can access private-market investments directly. For those without access, return outcomes are limited. Although there are opportunities to invest in listed versions of private-market investments, these are also limited.
Crucially, as individuals are now expected to be responsible for their own retirement planning, this inequality in investment choices is likely to exacerbate income inequality still further.
Some policymakers and regulators appear to recognize this, but the private markets still have a long way to go to become institutionalized to the extent that they could be considered appropriate for retail investors to access directly.
Growth drivers still in place
Private markets face several near-term risks. These are perhaps particularly pertinent given that we are a long way into this expansionary economic cycle. However, having the option to access the illiquidity premia and opportunity set that private market investments offer is becoming increasingly important in order to achieve diversification and optimal risk and reward outcomes.
The drivers of the shifts from public to private markets and from active to passive investments remain in place, and we expect private markets to continue to grow. Public market investment opportunities are shrinking. Given the high valuations and low yields on offer, this adds further impetus to the argument for investing, in a selective way, into private markets.
Among the risks presented by private equity investing are substantial commitment requirements, credit risk, lack of liquidity, fees associated with investing, lack of control over investments and or governance, investment risks, leverage and tax considerations. Private equity investments can also be affected by environmental conditions / events, political and economic developments, taxes and other government regulations.
Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.
Companies mentioned for illustrative purposes only and should not be taken as a recommendation to buy or sell any security.
Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.