They are illiquid, hard to access, difficult to research and not especially transparent.
So what accounts for the 16x growth of private assets over the past 30 years to become an £8 trillion juggernaut[1]?
Not long after the dawn of my investment career – let’s say the 1990s – investors in US listed equities were spoilt for choice, with a smorgasbord of over 8,000 companies to choose from. Today, that number is closer to 4,500.
The US market is by no means alone in seeing its ranks thinned out. In the UK, the number of listed companies has fallen by roughly 40% since 2007.
Something else has changed, too. Today, investors face an extraordinary degree of equity market concentration, with a mere 10 companies accounting for nearly 20% of the MSCI All Countries World Index.
Just as listed markets have shrunk and concentrated, the private markets have ballooned, diversified and evolved.
And therein lies the rub for today’s investors: opportunities for genuine diversification and for long-term growth from industries of the future are becoming scarcer in listed markets. But do the returns from private markets justify the effort, fees, illiquidity and opportunity costs of allocating to them?
We believe they do, though with some carefully considered caveats.
Does private equity do it differently?
The returns from unlisted and listed equities flow from exactly the same source: economic growth leading to profits growth and creation of enterprise value. From an absolute return perspective, one might therefore expect that listed and private investments should, on average, perform similarly.
However, private markets managers (known as general partners, or ‘GPs’) cite a number of factors that they believe enable private market investments to achieve higher returns than equivalent listed opportunities. A shortlist of these includes:
- Access to high-growth companies long before they are accessible via public markets
- The ability to apply expertise to improve private companies’ operational efficiency
- Better access to capital, use of debt and efficient balance sheet management
- Ability to focus on long-term objectives, not short-term performance
As we outline in the Compendium of Investment, various studies have investigated whether these factors can be directly linked to returns. However, an essential take-away for investors is that each private equity manager and vintage[2] will show different biases, and that there is a very wide range of returns between the best and worst managers, funds and vintages.
It is therefore difficult to make generalisations that apply across private markets investments and vintages. This highlights the importance of choosing an experienced team of private markets specialists who can offset the risks of making poor investment decisions in this area through sound research and diversification between managers and across multiple vintages.
How big is the illiquidity premium?
Anyone who invests in private equity must be prepared to have their capital tied up for a number of years. In return, investors naturally expect to receive an illiquidity premium – a higher return as recompense for not having access to their capital.
A great deal has been written about whether or not a private equity illiquidity premium exists once fees and other costs are taken into account, and the subject has generated lively (often heated) debate, both in academic circles and in the press.
Underlying the sometimes stark differences of opinion on the subject is the fact that, historically, it has been difficult to provide private markets returns that are relevant and easy to compare with other asset classes. However, the increasing transparency of private equity and the availability of better (but by no means perfect) measures of performance such as Public Market Equivalent (‘PME’), do now enable investors to make absolute and relative judgements about the asset class.
Notably, a recent independent study by CEM Benchmarking of 200 public and private sector pension funds between 1998 and 2021 found that private equity has produced a significant illiquidity premium relative to listed equities – if one compares gross returns (i.e. returns before costs).
Of course, gross returns are not what an investor receives and the costs incurred when embracing private assets are very significant: having analysed a range of academic and industry sources, we factor in about 4% per annum, acknowledging they can range between 2% and 8% per annum depending on how you implement your allocation and how much you end up paying in performance fees.
However, even after the costs of management are factored in, an illiquidity premium remains. While it effectively halves, the net average return for private equity has still been 1.7% to 3.9% per annum higher than similar listed market equities, equating to a premium of 18% to 56%.
Please note though, that in the model of future returns published in the Compendium of Investment (see our article detailing this here), we factor in a more conservative premium return for private equity for the period ahead of 1.35x above listed market returns, net of costs.
How liquid are private assets?
In its early years, private market investment was truly illiquid. Over the past 10 years, huge growth in secondary markets for funds of private assets has gone some way to improve liquidity. However, secondary market prices in the current market cycle are at discounts to net asset value (NAV). For good-quality buyout assets these discounts are around 7-10%, with riskier or longer-duration assets, such as venture investments, often at 25%-50% discounts.
Whilst secondary private markets offer a route to liquidity, we would not recommend that investors depend on being able to sell their holdings at a decent price in the secondary market. These types of assets should be considered illiquid and not readily realisable at their full value until they wind up.
A second key liquidity consideration is the pattern of cash flows when investing in private equity. When a private equity fund launches, investors commit their first instalment of capital, which is invested as the GP finds opportunities. Then, part-way through the life of the fund, capital starts to be returned to investors as investments are realised. When all investments have been exited, the fund winds up.
After a reasonable length of time (around 5-7 years), further capital calls[3] can be covered by the return of capital from investments made in prior years, thus maintaining a relatively neutral cashflow.
There are times, however, when demand for fresh capital exceeds the return of capital. This is particularly likely if private assets valuations are depressed. GPs will not wish to sell existing holdings but they will want to invest in new assets at depressed levels, and may require investors to commit further capital. Again, we would urge investors to treat private markets as illiquid and not rely on hopeful short-cuts to realising gains or meeting cash flow demands.
Not for everyone
We fully acknowledge that making an allocation to private markets is not a straightforward decision. The range of returns between managers and the importance of identifying and accessing the best managers should not be underestimated, and nor should the implications of holding illiquid assets. Investors also need to consider how their ethical requirements might be applied within illiquid and sometimes opaque private market vehicles.
Lastly, there is a much greater difference between gross and net returns in private markets than elsewhere. Asset owners will reach their own conclusions as to whether the net results make the journey worthwhile. Certainly, anyone considering allocating to private markets should read widely on the subject and discuss the pros and cons with advisers who have expertise in constructing global multi-asset portfolios.
If one can manage the issues of manager selection, access, illiquidity, ethics and cost, it appears logical to us that genuinely long-term investors should consider allocating to private markets.
Looked at another way, if you wish to own an equity portfolio with similar overall risk, return, maturity and industry exposure characteristics to one of 20 years ago, today it would be made up of a mix of listed and unlisted investments.
[1] The data cited in this article is from The Compendium of Investment, 2024 edition, Sarasin & Partners, pp59-67.
[2] ‘Vintage’ refers to the year in which investment capital is delivered to a private markets project or company.
[3] Capital calls are periodic additional capital commitments that are required during the life of a private markets investment in addition to the initial investment.
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