Private Markets: the top 3 myths for retail investors
In today’s market environment of low yields and high inflation, the quest for returns to meet investor outcomes has become challenging through traditional asset classes. For decades, large and sophisticated institutional investors have tapped private markets to help meet their portfolio objectives and today remain the predominant investors with allocations generally ranging from 10% to 20%.*
Investors are attracted to private markets for different reasons, including access to the significant investable opportunity set that exists across the universe of private companies, companies are staying private longer and creating greater value for their owners prior to sale or going public through an initial public offering (IPO), along with lower volatility potential when compared to public equities. Moreover, one of the most sought-after benefits is the potential for greater returns relative to public markets. Indeed, buyout returns have outperformed on a public-market equivalent basis against the MSCI World Index (representing world stocks) for all but one of the last 20 vintage years.1
However, implementing a successful private markets program as part of a total portfolio is not without some implementation challenges. High-Net-Worth or accredited investors, in particular, face some issues that need to be solved for including “J-Curve” mitigation, multi-year commitment periods, potentially high minimum investment sizes and illiquidity. With that said, accredited investors can potentially improve their investment outcomes by partnering with firms that have the requisite scale, demonstrated access to top-tier investment opportunities and specialist investment & portfolio management expertise.
Let’s take a closer look at three of the top myths for retail investors to consider—and how to potentially solve these implementation challenges to successfully gain exposure to private markets.
Myth 1: Investors need to participate in capital calls and experience negative returns in the early years of a fund
In private markets, the “J-Curve” is the term commonly used to describe the tendency for investors in closed-end funds to experience negative returns in the early years of a fund’s life cycle. This occurs because capital commitments take several years to be “called”, yet fees are charged (on committed capital) prior to realization of returns such as distributions or the sale of portfolio company investments. And while the J-Curve reverses over time as investments are made with private assets, the fund’s net asset value grows and investments are realized, investors are nonetheless exposed to negative returns in those early years, particularly with primary fund investments.
There are however strategies that can be utilized in order to reduce both the depth and length of the J-Curve in a private markets investment allocation. In working with investors to implement their desired strategic asset allocation targets to private markets, a key component of the portfolio construction tool kit is the use of secondary (purchase of existing interests in private markets funds) and co-investment (investments directly into companies) strategies. By building a portfolio of private markets investments across equity and credit strategies, and utilizing both secondary and co-investment access points, an investors capital can be called more quickly, returned faster and potentially see positive performance very early on.
One way to overcome these issues is to invest in private markets using what is known as an “evergreen” fund structure. An evergreen private markets fund is an open-ended investment vehicle that does not have a terminal date and is effectively available for making new investments at any time. With some evergreen funds, investors can gain access to already existing investments, beyond the phase for capital calls.
Myth 2: Investing in private markets requires a long time-horizon and high investment minimums
One of the most common issues that arises when investing in closed-end private equity funds (also known as primary funds) is that they typically have a 10-year life and the underlying portfolio company investments are made over the first five or so years of the fund’s life. The implication for investors is that it often takes multiple years of commitments to build and maintain a desired asset allocation target to private markets.
Another hurdle is the high minimum investment size associated with investing in top-tier private equity managers which are usually in the $5-10 million range. As such, building a diversified portfolio across manager, strategy, geography, asset and vintage year is practically impossible for retail investors.
Evergreen funds benefit from commingling a large number of investor’s capital together such that a well-diversified portfolio of investments can be built with lower investment minimums—i.e., $50,000 for each individual investor (provided they meet accredited investor criteria), thereby providing diversified exposures to private markets through a single allocation.
Myth 3: Private markets investing is iIliquid and investors cannot easily access their money
As previously noted, traditional private equity funds typically have a 10-12 year commitment and are considered illiquid investments, meaning investors cannot easily access their money. There are strategies that retail investors can utilize that display more favorable liquidity profiles, particularly secondary and credit investments which have the ability to generate cash flows and create liquidity sooner.
As secondary investments are comprised of existing portfolio company investments, they are more mature in their lifecycle when compared to primary fund investments. The more developed nature of the underlying assets can translate into significantly shorter timelines to either distributions or full realization, therefore providing cash back more quickly to investors.
In the case of private credit investments, the average lifespan of these loans is typically between three and four years.2 In addition, a major source of returns generated in private credit is the income stream derived through cash flows from either operating company assets or physical assets, such as real estate. Through this combination of a shorter loan lifespan and ongoing interest payments, the cash flow profile of private credit portfolios helps to alleviate the typical illiquidity associated with investing in equity oriented primary fund investments.
Compared to traditional private markets funds, evergreen funds may be more flexible, providing monthly or quarterly redemptions. Generally speaking, the fund will allow a set percentage of assets to be redeemed in any given quarter.
It is not surprising that as investors seek to address the challenges of generating returns, improving diversification and reducing portfolio volatility they are increasingly turning to private markets to improve their investment outcomes.
Ultimately, partnering with firm’s that have the requisite scale, demonstrated access to top-tier investment opportunities along with specialist investment and portfolio management expertise can maximize the probability of success—and in doing so help investors realize the benefits that private markets have to offer in a total portfolio.
* Source: McKinsey Global Private Markets Review 2021
1 McKinsey & Company, McKinsey Global Private Markets Review 2021, April 2021. Vintage year is the first year that a private markets fund calls capital.