This week it was reported (Reuters, Bloomberg et al) President Trump is expected to sign an EO (Executive Order) in the coming days to help make private market investments more available to US retirement plans. It’s early days (or not – we will see) but such an EO would instruct the US Labour Department and SEC to provide guidance to employers and plan administrators on including investments like private assets in 401(k) pension plans, a £12.5tn marketplace!
It’s argued this will provide “diversification and investment options needed to build wealth and save for successful retirement”. Details are still being discussed but, if this goes through, it would be a big win for Private Markets whose participants have been trying to get a piece of this $12.5tn held in 401(k) pension plans for some time.
As it stands, Institutions and Pension funds are pretty much maxed out in terms of what they can allocate. There will undoubtedly be pushback. Senator Elizabeth Warren, a top-ranking Democrat on the Senate Banking Committee, has stated her primary concerns (as per her letter to Edmund Murphy III, President & CEO of Empower Retirement) and cites weak investor protections, lack of transparency, expensive management fees and unsubstantiated claims of high returns among some of them (for the full letter, refer to the following link: https://www.banking.senate.gov/imo/media/doc/Warren%20letter%20to%20Empower%20on%20PE.pdf).
There is definitely a momentum building around Private Capital markets. More and more references are being made to it in media releases – be they academia and/or institutional research pieces. Private Markets refer to investments in the capital of privately, owned companies (vs those of publicly, traded companies on exchanges). Essentially, there are six main classes: Private Credit, Private Equity (Secondaries and Venture Capital), Private Infrastructure, Private Real Estate and Natural Resources.
Reasons cited in their favour include: (1) Inflation hedging; (2) Reduced volatility and (3) Higher return potential.
Reasons cited against include: (1) Poor – even non-existent – liquidity; (2) Lack of transparency; (3) Valuation methodology; (4) Lock up periods; (5) Lack of Regulation and (6) Lack of investor protection.
So, why have investors and Regulators had a phobia about them?
To put it bluntly, until now, there hasn’t been a need to invest resources into something requiring more analytical work vs plain vanilla, traditional investments! The former is unregulated and uninsured. The latter is traded and regulated. Such has been the stimulatory economic environment of at least the last 10 years (QE and cheap money) that investing in publicly traded companies (directly or via funds) with daily liquidity have quite simply shot the lights out of anything else out there.
Meanwhile, bonds – thanks to QE, low rates, yields and inflation – have been the best alternative to cash! Bad press has not helped private markets either. For example, March 2020 saw upheaval in the US mortgage market as certain REITs (Real Estate Investment Trusts) failed to meet margin calls from lenders as the price of mortgage bonds slid. Two such firms were MFA Financial (which lost 87%) and Invesco Mortgage Capital (which lost 53%). In October 2023, M&G suspended its Property Portfolio because it became “less popular” with investors and “anticipated continued withdrawals which could negatively impact the fund’s performance and make it necessary to sell properties at potentially lower prices” (Source: ReAssure).
Suddenly, all that’s changed! Post February 2022 (Russia’s invasion of Ukraine), we find ourselves in a whole, new environment: inflationary, indebtedness, high yields and persistently elevated volatility – not to mention the hugely increase geopolitical uncertainty and the tariff wars. Add to this heavily constrained fiscal budgets – and now governments are looking to retail monies to do their heavy lifting for them! It’s not just the US – it’s happening in Europe and the UK too.
The new environment is no longer conducive to yesterday’s strategies. We’re still adapting to this new regime. Asset managers are now scrambling to stay in business. Throw into the mix new regulation (e.g. Consumer duty in the UK which effectively forces an asset manager to parse the fee they charge to clients to justify value-for-money) and they’re suddenly feeling the heat.
Enter Private Markets! This segment genuinely offers an alternative way of investing from the world of Alternatives. The table below is a very high-level comparison of some key distinctions between fixed income and equity and why this category offers diversification over public investments:
| Public | Private | Comment | |
| Fixed Income | Fixed maturity – issued at par, redeemed at par but trade-able over its duration in primary and secondary markets (“riding the yield curve”); market-linked coupons; standard covenants. | Fixed maturity – issued at par and only redeemed at par; negotiated coupons (due to its business bespoke nature) with typically higher rates well above inflation; stricter covenants and security coverage. Durations range from very short (under 3 months) to very long (several years). | A bond is a bond! If you buy and hold it, you exit at the same price as when you started. Your gain is the coupon plus any upside from convertibility and/or warrants built-in; meanwhile, the underlying investment enjoys market stability from short-sellers and activists. Private Markets reduce Risk based on the covenants and security sought. Further risk mitigators in private markets include Board positions and vastly better Governance (see-through). |
| Equities | Buy via market exchanges, sell via market exchanges. That’s it! | Negotiate equity blocks with vastly preferential terms and carry, management access and far better governance…..essentially all the benefits of fixed income bolted on. | Typically, private equity offers (much) higher returns. You are capturing alpha in its purest form – when a company is in its early phase (under 2y to 3y) as opposed to developed and maturing. Imagine investing in a tech company when it was a startup/VC vs when it became listed; alternatively, imagine investing in a listed company but negotiating a private equity deal to help expand operations and business development. |
It should hopefully be apparent that the diversification often spoken of stems less from the fact that private markets are valued differently but more from the way they are structured! This is a really key distinction. Critics often speak of the “illusion of volatility” arising from the lack of regular, daily pricing…..but they’re missing the point: the point being that private capital is tailored/bespoke to the company. This is its whole reason for being. In the event the investment hits stress/distress, different risk mitigators kick in allowing lending firms to recover monies first in the pecking order. Full recoveries are not always guaranteed – but the chances of it are vastly higher due to the structuring (the covenants and security). There is no illusion or myth – it simply requires resources to thoroughly analyse (time, money and acumen)!
Things for investors to consider when delving into the world of private markets: what is my duration risk (DR) and what is my illiquidity risk premium (IRP)?
DR is all about how far you can stomach going beyond your comfort zone (assuming the latter is the world of traditional, daily dealing instruments). It is quite wrong to think or assume every private market opportunity means you are banged up for years on end! This is a nonsense – we are finding more and more opportunities in situations ranging from less than 3 months to a max. of 3 years.
IRP is how much more you want to be compensated for the extra DR you are taking! As an example, some years back, Hermes did a study on what the IRP might be for a range of private market opportunities. Following the GFC in 2008, it shot out to as high as 3% (300 bps) in the Direct Lending Mezzanine space. Under normal market conditions, it is under half this. Trade Finance – another strongpoint for us in-house – carries an IRP of a mere 0.15% to 0.20%. Invoice Financing is in a similar ballpark.
Conclusion:
- Private markets are NOT risk-free – but they certainly have a better set of risk mitigators built-in from the way they are structured vs their public counterparts!
- The diversification private markets bring to a portfolio stems less from the way they are valued but more from the way they are structured. The true price is the price at crystallisation of a deal (i.e. entry and exit point). That’s how true alpha is unlocked.
- Never lose track of weighing up the DR (Duration Risk) with IRP (Illiquidity Risk Premium). Know your threshold for both.
- The main threat to private markets is if public markets should return to a high-returning scenario. Today’s environment doesn’t support such a return!
- The desire by governments to encourage retail investment, via pension savings, into private markets is clear. Even if only 10% of the above-referenced $12.5tn goes into private markets, that’s still huge.
MARKET SUMMARY…
