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GOING PRIVATE: CONSIDERATIONS FOR INVESTORS ALLOCATING TO PRIVATE MARKETS
February 28, 2023 | 5 Minute Read
Michael Moran
CFA, Senior Pension Strategist
Michael Moran
Daniel Murphy
Head of Portfolio Solutions for Alternatives Capital Markets and Strategy
Daniel Murphy
Wael Younan
Senior Lead Portfolio Manager, Multi-Asset Solutions
Wael Younan
Many institutional investors have established or raised target allocations to private markets in recent years, and there is increasingly interest from more investors to go down a similar path. These actions have been driven by a number of factors, including:
1. Consistent outperformance by private equity and private credit over the last several decades compared to public markets. As seen below, over 10, 15 and 20-year time horizons, both private equity and private credit have outperformed public market equivalent returns.
Exhibit 1: Private Market Performance
Source: Cambridge Associates, data as of June 2022. Private equity and private credit returns shown net of fees. Past performance does not guarantee future results, which may vary. For benchmarking purposes, public market equivalent (PME) returns reflect the performance of a public market index (“index”) expressed in terms of an internal rate of return and takes into account the timings of a private equity fund’s cash flows. PME returns do not represent the actual performance of the index. Indices are unmanaged and investors cannot invest in indices. The index returns used to calculate PME returns are gross total return, with dividends reinvested and do not reflect the deduction of any fees or expenses, which would reduce returns. MSCI World Index used as the public equity market index; S&P LSTA Leveraged Loan index used as the public loan market index. For educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.
2. Opportunities to access innovation and value creation that may not be available in the public markets. This is especially true in the case of private equity. As seen below, over the past two decades the number of private equity-backed companies has grown significantly, while the number of publicly listed firms in the US has contracted. New companies are choosing to stay private for longer, often leveraging growth equity capital to expand their businesses before becoming publicly listed. Much of the growth and value that was previously generated post-IPO is now being built under private market ownership.
Exhibit 2: The Universe of PE-Backed Companies Has Grown While The Universe of Public Companies Has Shrunk
Source: Private equity companies over time: PitchBook, as of 12/31/2022. Public companies over time: World Bank, McKinsey.
3. Muted forward-looking return expectations for public markets in comparison to historical returns. Even with the drawdown in public equity markets in 2022, many valuation measures are still at the higher end of historical averages. Interest rates, while also having risen the past few quarters, are still lower than they have been in recent decades, providing a constrained starting point for future fixed income returns. With prospective public market returns likely to be lower than what these asset classes have delivered in the past, many investors are looking to private markets to help them achieve their nominal long—term return objectives which often fall between 6.5% - 7.5%. Active risk will likely play an increasingly important role in portfolios over the next several years.
4. Diversification benefits offered by private real assets. Real assets offer diversification across return drivers and degrees of sensitivity to economic cycles and factors. They also offer diversification to public markets, in terms of investment scope and correlations of returns, as seen below.
Exhibit 3: Private Real Assets: Low Correlations to Public Asset Classes
Sources: Private assets: Cambridge; public assets: Reuters Eikon. Global equities proxied by the MSCI World index, global high yield Bonds proxied by the Bloomberg Barclays Global High Yield index, real estate proxied by the FTSE EPRA Global NAREIT index, infrastructure proxied by the FTSE Global Infrastructure index. Data for 15 years through 2Q2022. Past performance is not indicative of future results. For educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities. Past performance is not indicative of future results.
However, for many investors that aspire to go down a path of building out their privates market portfolio, the question is how to get to there from here? Wanting to establish or increase exposure to private markets raises a number of questions from a holistic portfolio management perspective, some of which could be operational in nature. We address some of these below.
What considerations should investors take into account as they look to build out their private markets portfolio?
- Managing differences in liquidity profile of public and private assets: A key portfolio management function in managing a public-private portfolio is striking the balance between investing uncommitted / uncalled privates capital vs ensuring sufficient liquidity for future capital calls.
- Vintage diversification: Having a diversified approach to investing in public and private markets including investing across multi-year vintages to maintain flexibility and improve risk-adjusted returns. An allocation to secondaries can provide an opportunity to attain the desired exposure to a particular asset class sooner than can be achieved through the primary market.
- Manage total portfolio risk: Closely monitoring overall portfolio risk and maintaining a balanced set of portfolio exposures.
- Portfolio rebalancing: Modulating the risk profile of the portfolio while seeking not to disrupt the desired balance of risks within the portfolio.
- Ramp-up and J-curve impact of privates: While the investor is seeking to build out its private asset exposures the portfolio will be under-invested relative to the long-run asset allocation.
- Cash management: Ensuring disciplined cash management in order to manage capital calls and distributions from private assets.
- Private investment valuations: Performance evaluation needs to consider the infrequent valuations of the private strategies, and how that may impact rebalancing actions.
- Performance evaluation: Even when invested, private strategies (particularly equity like) can take time for portfolio assets to have their business plans realized and then reflected in re-rated valuations. As such performance evaluation needs to consider such non-uniform exposure and return profile.
Individual commitments often start distributing capital before they are fully invested. How should an investor build toward a target allocation in private markets strategies?
It is tempting for many investors to try to ramp up private markets exposure quickly by making large initial commitments, then filling in with smaller commitments as the initial investments begin to distribute. However, this approach can lead to a continual game of catch-up since new commitments take time to draw down and may not keep pace with distribution activity, as well as reducing flexibility in managing a program should the environment turn out to be much different than was initially expected. A program of making relatively similarly-sized commitments to private markets on an annual basis may take longer to achieve the targeted asset allocation, but can also help ensure that the portfolio maintains a reasonable level of diversification and preserves the flexibility to reduce commitments and mitigate the “denominator effect,” and/or lean into areas of particular tactical interest should markets weaken. Moderately larger initial commitments, or allocations to strategies offering a higher velocity of capital, can help build allocations more quickly, but significant over-commitments can reduce flexibility and optionality exactly when it would be most valued.
Establishing an allocation to private markets can take time. As an investor goes along the journey, in the interim, what else can they do to replicate the exposure?
Creating a robust equitization framework for capital that has yet to be called for private investments is imperative for organizations that are looking to build out an allocation to private securities. Exhibit 4 illustrates a typical journey an institutional investor may go own as it builds out a private markets program. In the early years, the allocation is dominated by public markets exposure, which is ultimately reduced as more capital is called into the privates program. Ensuring those allocations are a sound proxy for private markets exposure can help the investor reap the benefits of the program in the earlier years.
Exhibit 4: The Journey to a Fully Allocated Private Markets Program
Source: Goldman Sachs Asset Management. As of February 2023. For illustrative purposes only.
Cash Reserve: A conservative estimate for upcoming 1 year capital calls
Private Markets: Represents Cumulative Capital Calls
Public Markets Investment Program: A liquid customized solution through a low to medium risk program across asset classes.
Another lever investors can use to establish an allocation sooner rather than later is through the use of secondaries. Allocating capital to secondaries can help reduce the J Curve effect and attain a desired exposure sooner in comparison to what can be achieved in the primary markets.
How can investors manage liquidity needs given projected capital calls and distributions?
Investors need to maintain discipline in their cash management in order to ensure they can meet near-term capital calls. This also includes forecasting and managing distributions from its private markets program.
Exhibit 5 outlines the typical flow of capital in a public/private portfolio. A cash reserve for meeting imminent capital calls for private commitments should be maintained at all times, even in more mature portfolios where distributions are expected to largely fund any capital calls since these distributions can be unpredictable and dry up quickly in dislocated markets. As distributions from more mature commitments occur, they can be used to replenish these cash reserves with excess amounts being reinvested in the broader public market portfolio to help with rebalancing activities.
Exhibit 5: Managing Cash Flows in a Public/Private Portfolio
Source: Goldman Sachs Asset Management. As of March 2022. For illustrative purposes only.
Cash Reserve: A conservative estimate for upcoming short term capital calls. As the program continues to mature, we will maintain an allocation to cash to manage cash flows accordingly.
How much emphasis should investors place on manager selection and portfolio monitoring?
A lot. Manager skill in private markets is not evenly distributed, magnifying the consequences for both good and bad selections. As seen below, several areas of privates markets have seen substantial dispersion in manager performance over time. This is particularly true for private equity managers. Given the long-term, illiquid nature of private equity investments, managers must be evaluated not only for their ability to create value in the current environment, but sustainably over time through a variety of market conditions. In addition, allocations to private markets is not a “set it and forget it” strategy as new commitments need to be managed each year.
Exhibit 6: Dispersion in Private Markets Has Been Substantial Over Time
Source: Cambridge Associates, as of Q2 2022. Represents the average dispersion to the median manager across vintages 2000-2018 within each strategy. Past performance is not indicative of future results. For educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.
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