Private Market: What's the secret?

"The world is changing very fast. Big will not beat small anymore. It will be the fast beating the slow." - Rupert Murdoch

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My youngest son had his first day of school this year, the amount of preparation and planning that goes into getting kids ready for school these days is quite intimidating, from the school uniforms and the books through to the lunch boxes (what you can and can’t put in them) not to mention the name tags. It only feels like yesterday that it was me getting ready for my first day of school and oh how things have changed.

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It is now normal for kids to have lessons using an iPad in the classroom instead of notebooks, you are no longer allowed to bring a peanut butter sandwich to school, with kids learning how to code at an earlier stage than I learned how to spell on computer. One of the Senior Schools we are considering sending our boys to has an entire building dedicated to hands on learning, with a robotics lab where students can create projects with 3D printing. The world is changing at a rate of knots and we either need to keep up or we’re left behind. 

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I remember when I was studying for the Chartered Financial Analyst designation (CFA) much of the course was designed around risk management and portfolio theory. Portfolio theory 101 states that theoretically there is a strong negative correlation between risk and return: the more risk the higher potential return and higher potential loss. I was also taught the safest thing you can buy is a government bond and one of the riskiest things you can buy is private equity. The last decade has turned this theory on its head as we’ve witnessed the safest asset in the world in government bonds return a negative 20% while private equity, arguably the riskiest asset remained relatively unchanged. What does this mean for portfolio construction moving forward?

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Textbooks didn’t predict this event over the past 100 years, so it certainly has a lot of people thinking about the basics of portfolio construction. Don’t get me wrong, I do believe with interest rates closer to long term averages then bonds should continue their job of being the safest place to park your capital, however private markets are certainly starting to get mainstream attention. The fact is less and less companies are listing on public exchanges and instead choosing to stay private for much, much longer. 

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Before we delve into the case for private markets, we will start by explaining exactly what they are.  When we talk private markets, we are typically talking about two very different types of investments. 

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The first being private credit and the second being private equity. The term private suggests that they are not traded on public exchanges and instead are transacted directly with another party. Instead, a public listed credit or equity transaction is facilitated using an exchange where buyers and sellers are aggregated by a central party. 

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Private credit is simply capital that has been lent privately either from a non-bank institution or an individual as opposed to in the form of a bank loan or corporate bond. Or in the case of government, government bond. This asset class has risen to popularity in recent years as banks have chosen to focus on more vanilla loans that require less vetting, while leaving the more time-consuming and complicated loans for private markets. It is however important to distinguish this doesn’t make these loans any riskier, simply more complicated - for that reason private markets demand a premium (higher) return. 

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This article will focus on private equity which is a form of investment into private companies that are not publicly traded on stock exchanges. It involves investors pooling capital together to acquire stakes of private businesses, the goal is to typically enhance the value and therefore performance of the invested companies and typically sell within a 5-10 year period. During that time managers are also diligent and hands-on involved in much better governance and management that might otherwise be the case, as the manager has ‘skin in the game’ as opposed a board managing the capital for shareholders who are distinct from the business.

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Private Equity (PE) used to be an asset class that only the very wealthy or institutions could access, as the minimum investment was typically $500,000 to $1,000,000 in Australia. Globally the minimum investment to access the higher profile (invitation only) funds were and remain as high as USD$10Million and typically come with a 10-year lock in period. However there have been large changes taking place in the past decade that have made access easier to all investors. 

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We have observed an increasing number of international PE funds, chasing Australian SMSF money, launching in Australia recently, offering semi liquid vehicles. These vehicles allow access to these funds, while reducing the traditionally high minimums to as low as $20,000, while offering a reduced lockup from 10 years to as low as 3 months. The funds achieve this by holding a higher weighting to cash than normal. 

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Alternative investments (including both private equity and credit) are growing rapidly, with total assets under management forecast to reach 21.2 trillion dollars by 2025 and account for 15% of total global assets under management . 

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The chart below illustrates a trend we have been following closely in markets for many years, which explains why private market investment has been growing exponentially. In explanation, companies are remaining private for much longer, while selling to the public market at much larger valuations than ever in history - meaning is a much greater opportunity in private markets for investors than there ever has been. 

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The number of public-company listings in the United States peaked in the mid-1990s, at nearly 6,000, however that figure almost halved over the past 20 years (by 2021) and the number of IPO’s has fallen sharply in the same period. 

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It is no surprise that a recent survey by the Financial Planning Association found that 28% of financial advisers actively invest in or seek alternative strategies for their clients and a further 19% are considering making an allocation in the next 12-24 months. That figure is nearly double in a global survey with around 50% of participants stating they intended to increase their allocations. An analysis by UBS proves that introducing alternative investments including private equity to a portfolio both lowers risk and increases return

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We will often refer to one of the most well managed investment funds in the country, The Australian Future Fund. Year after year Australia’s largest Sovereign Fund (now valued at well over $200Billion) has been increasing its allocations to private markets to this now stands at 43.5%, well up from its initial allocation to private markets of only 14.2% when establishing the fund during 2006. A very similar thematic can be observed when looking at the Yale Endowment fund, another stand out in stellar financial management over decades and multi-generations.

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In 2019 State Street commissioned a study into the risk/reward profile of private equity and if it deserved to be labelled as riskier than public equity, the findings were quite astonishing. The article opened by stating that on an observed basis, private equity appeared to have higher returns and lower volatility than public equities. 

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To balance the article, it made a reference to an earlier study suggesting that private equity is in fact riskier once you consider the fact private equity is not valued as frequently, making comparisons to leveraged small caps however the report goes on to debunk this by studying the volatility in their earnings compared to listed counterparts. The report found convincingly that PE has less volatility in earnings compared to broad public equities as well as a much higher return (on average). 

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What is the secret to Private Equity Returns and why does it appear to return more than public equity?

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A 2007 Harvard Business Review article titled 'The Strategic Secret of Private Equity' aimed to explain why Private Equity appears to achieve higher rates of return. According to the article, Private Equity firms will acquire companies for much shorter periods than public ownership, sometimes as short as three years, implementing strategic measures to enhance performance during this time. The article illustrated that through these improvements, a company acquired by Private Equity can realize an accelerated rate of return within the initial three years. In contrast, a public company may introduce the same strategic changes but would likely opt to retain the acquired entity, resulting in a more gradual return over time, moving closer to the lower, sustained rate of return over a much longer period. 

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An article written by Hamilton Lane (one of the largest private Asset Managers in the world) found the only year that private markets beat public markets in the past 20 years was during the year 2000. This fact for all the 10-year periods since the turn of the century, again proving private market outperformance. 

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A general assumption might be private equity has higher returns, while it should return lower in more challenging years than public markets. However even during the GFC and the dot com bubble, private equity outperformed during both the downturn and recovery periods of all public markets. 

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Source: https://addx.co/insights/why-private-markets-tend-to-outperform-public-every-time-even-in-down-markets/

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The private equity return premium exists for a few key reasons – some of those being:

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Opportunity Access

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The list of available investments across public markets are very limited and are exposed to an enormous amount of compliance and scrutiny as a publicly listed company. Being listed entities, they are often much larger institutions than private market companies so to find an acquisition that is going to make a meaningful difference is also much harder. As a listed entity, due to the shear universe of investors on the share registry and attention from investment houses, in most cases these assets should be fairly priced. 

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Private Equity on the other hand have access to an unlimited number of opportunities that are not subject to the same scrutiny and attention that public markets receive. Private equity firms offer specialist teams who can identify and perform the due diligence on the opportunity and invest more nimbly and much earlier, meaning there is much greater investment upside. Often the deals they consider will have little competition, so they will rarely enter a bidding war for an asset. 

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Active Management

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Private equity firms can also be active managers meaning they can actively become involved in the management of the company, while using their skill to set out strategic initiatives and operational improvements that can ultimately increase value. This is not possible for a public company. 

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Longer Time Horizons and Flexibility

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Private equity firms can also take advantage of longer time horizons than public equity, they are not held accountable by the share price volatility on a daily basis. Instead, they can focus on creating meaningful value over the long term. They are also privy to much more flexibility and ability to make decisions and adapt to market conditions much faster than their listed counterparts. 

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Private Companies Will Often be Founder Led

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It is much more common to have a founder with real skin in the game leading a private equity portfolio company than a listed company where the founders have often exited already. This tends to lead to greater returns on average. 

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So, if private equity Is lower risk and higher return then why wouldn’t shouldn’t you invest the majority of portfolio in private equity? 

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This article has been written using averages and mediums as the proxy for private equity as an asset class, however there are huge discrepancies between the top quartile and the bottom quartile managers, asset manager selection is critical. One of the reasons the return is higher can be explained by the “illiquidity premium”. This simply refers to the premium (higher) return an investor will receive due to the fact they are unable to access their capital for periods of time (often 10 years). Over that time an investor does not realise any dividend or income, instead this income is used to grow the businesses (reinvestment of capital, which compounds), typically for the first 5 years.

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The below chart shows what can happen in a hypothetical scenario of adding private equity to a 60% equity 40% bond portfolio and shows in all scenarios that the return is increased, and volatility decreased.  

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Source: https://www.moonfare.com/pe-masterclass/why-invest-in-pe

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As with any investment, it must be carefully thought out and analysed on a case-by-case basis. You must calculate which specific assets/funds are aligned to your own personal goals. Private Equity funds are complex investments and come with several caveats which must be taken into consideration prior to investment. This is the job of a qualified and experienced investment advisor.

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With many of the World’s most influential and experienced institutions allocating a much greater share of their long-term investment capital to private markets than ever over the past decade, this is certainly a trend which is continuing. 

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As investment advisors’ private markets have and will continue to be, an investment area we will continue to focus much more research and diligence on. We expect private markets continue to become an even greater component within a diverse, long-term investment portfolio. 

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"It is not the strongest of the species that survive, nor the most intelligent, but the one most responsive to change." - Charles Darwin

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