Key points:
- Private market investments are investments that are not traded on public exchanges. They include things like private equity, venture capital, unlisted real estate and infrastructure, as well as private credit.
- Private market funds are the most common way for investors to access private market investments. Private market funds are different in that they have a finite life, low levels of liquidity, and irregular capital calls. However, the controlling stakes of private market funds allow their professional managers to influence and execute on value-creation initiatives like operational improvements, technological investments and/or strategic market expansions.
- Private market investments offer the potential for higher long-term returns (often exceeding those of traditional assets like shares), lower return volatility, and improved diversification. According to a study by PitchBook, private equity funds generated a median net internal rate of return (IRR) of 11.0% from 2000 to 2021, outperforming public markets.[1] For reference, the annualised returns of the ASX 200 was approximately 4.45% since 2006.[2]
Introduction
I’m currently planning the family holiday and I’m faced with two options:
- The well-trodden path, a simple and easy guided tour offered by a tourism website that will give us a great overview of our destination, but it doesn’t seem to be all that rewarding nor does it suit our preference for more unique experiences.
- The off-the-beaten-track adventure is bespoke, more challenging and complex, with more planning involved (e.g. what are the food options, will I have to carry for my seven-year-old so she stops complaining that her legs are tired), but the potential rewards and views are just so much better.
Now here comes my longbow. . . planning for the family holiday can be like reviewing an investment portfolio. The well-trodden path being public markets (shares, bonds, cash etc.) and off-the-beaten-track, being private markets. Private markets may appear to be complex, but with research and some thoughtful planning and implementation it can lead to financial outcomes that are truly worth the effort.[3]
In this series, we're here to simplify the complex world of private market investments, making it accessible to everyone.
Private Market Investments: Demystified
Private market investments are, in essence, investments in assets that aren't traded on public exchanges. Both the local family-owned restaurant and Gina Rinehart's Hancock Prospecting are examples of private companies as they are not listed on the Australian Stock Exchange.
The term private markets is very broad and investment opportunities in it span the risk/return spectrum. For example, it includes asset classes like private equity, venture capital, real assets (real estate and infrastructure), private credit and more (as shown in the chart below, which is indicative only since there is a broad range of strategies within each asset class).
Unfortunately, private markets suffer from an image problem. When I was a teenager, my perception of private equity was shaped by Barbarians at the Gate (the 1989 book by Wall Street Journalists Bryan Burrough and John Helyar, which was subsequently turned into a movie in 1993, about the leveraged buyout of RJR Nabisco). In that move, private equity seemed to be a world full of exclusivity, cutthroat deals, and greed. But as I progressed through my professional career and interacted more with the private equity industry my perception has evolved, and there now appears to be a greater desire to make good companies great. That is not to say that those characteristics do not exist in some pockets but what is clear is that private market investments, once considered the domain of the financial elite, are becoming more accessible to wholesale investors through technological advances and lower minimum investment requirements.[4]
What makes private market investments different to public market investments?
Most investors access the private markets through funds. Private markets funds are similar to their listed counterparts in that many investors pool their capital together for a professional manager to invest it. However, a fundamental distinction lies in the nature of the investments. Unlike public market funds that invest in listed shares or bonds, private market funds are involved in:
- Acquiring entire private companies or newly formed startups in the case of private equity and venture capital;
- Procuring or developing real estate properties, or essential infrastructure assets like toll roads, airports, and ports; and
- Providing loans to companies unable to issue bonds in the case of private credit.
In stark contrast to public market funds, which typically acquire small stakes in assets, private market funds often secure controlling or significant ownership interests. This substantial ownership not only grants them influence at the board level but also provides the fund manager with the authority to shape strategic agendas and impact operational and management decisions. This dynamic role at the board level is a pivotal driver of investment performance for private market funds, diverging significantly from the limited influence exercised through votes at Annual General Meetings in the public share markets.
Other key differences between private and public market funds come about because of the way that they are structured. Traditional private market funds have capital calls, meaning that the fund manager will notify investors when they need capital from investors to buy a new asset. Capital calls are a feature of private market funds because there is a lot of due diligence and legal work involved in purchasing private assets. This results in a significant amount of time needed to execute a buy or sell decision. Because of the lengthy execution time, fund managers will only call for capital when it is needed rather than have it sit in cash.
Time is also needed by private markets fund managers to successfully execute their strategic and operational improvements. This results in an investment hold period of generally between three to six years for individual investments, and an investment term of 10-12 years for a diversified portfolio of investments. This is why private market funds are illiquid and investors cannot simply redeem whenever they want to.
In contrast, investors in public markets can invest and redeem whenever they want because the fund manager can simply execute a buy or sell order almost instantly.
So, why would you invest in the private markets given all these complications?
The million-dollar questions: Why invest in private markets? What are the benefits of investing in private markets?
Private market investments offer the potential for higher long-term returns (often exceeding those of traditional assets like shares), lower return volatility, and improved diversification.
The chart below illustrates how the value of $100 would have grown between 31 December 2000 and 31 December 2022 if it were invested in private equity versus had it been invested in the US share market or global share market over the same period. It shows that the $100 would have grown to over $920 if it was invested in private equity (as represented by the PrEQIn Private Capital Quarterly Index after fees), while it would have only grown to approximately $460 in the US share market (as represented by the S&P 500 Total Return Index - Unhedged in AUD terms) and $360 in the global share market (as represented by the MSCI World Total Return Index - Unhedged in AUD terms). It also shows that the ride along the private equity path was also smoother (i.e. less volatile and shallower draw-downs).
However, the private markets are not just about financial gain; you are also contributing to innovation and growth. Private market investing is a chance to be a part of groundbreaking ventures, real estate developments, nation-building infrastructure and more.
Risks and Considerations
While private equity can provide benefits such as increased returns and diversification, investors need to weigh specific considerations before deciding if it's the appropriate investment route for them.
- Management fees: Assessing a fund necessitates examining its net performance, after fees, instead of solely concentrating on gross return metrics. Fee transparency is essential.
- High minimums: Conventional private equity investments frequently demand high minimums, which may deter individual investors.
- Low liquidity and postponed cash flows: Private equity funds generally have lock-up periods, rendering them as long-term, illiquid investments. Moreover, a private equity fund's investment and profit realisation schedule can cause delays in cash flow for investors.
- Risk of loss: Private equity investments carry a high level of risk and may lead to partial or complete capital loss. Alternative investments are intricate, speculative instruments appropriate solely for qualified investors possessing adequate knowledge and experience to comprehend the associated risks.
