Many investors are seeking alternatives to traditional stocks and bonds in today's volatile political and economic environment.
One such alternative that has gained significant traction is private markets. These investments – perhaps a solar farm, a hospital, a tech start-up or even an electric micro-mobility vehicle maker – often offer unique benefits that promise stability and growth even in uncertain times.
What are private markets?
Private markets refer to investments that are not traded on public exchanges. They can be split into two main categories:
- Private capital – such as investing equity in ventures or buyout transactions, as well as lending money to private companies and projects.
- Real assets – such as real estate, infrastructure projects, or natural resources like timber or agricultural land.
Unlike public markets – where most securities are bought and sold openly on a near-daily basis – private market investments are typically made ‘over the counter’ through direct transactions between investors and companies or funds. That’s why they are labelled ‘private’ and are often illiquid.
Listed companies represent only a small fraction of the registered companies around the world while borrowing from bond markets is only open to firms of a decent size.
Investing in private equity and private credit can increase opportunities to enhance portfolio performance. Meanwhile, financial innovation and the needs of private capital have also opened a new set of investment opportunities.
Those structural changes, coupled with higher volatility in public markets, have fuelled investments in these ‘alternative’ investments. Assets under management rose from US$2 trillion in 2003 to US$25 trillion in 2023. One estimate sees this market hitting US$59 trillion by 2033.
However, this is changing. Innovations in financial technology and regulatory changes have made it easier for a broader range of investors to participate.
Additionally, there has been a growing trend towards ‘evergreen’ funds and semi-liquid pooled investment vehicles that offer investors more dealing flexibility with regards to commitments and withdrawals, compared to traditional private market vehicles.
That said, still-sizeable investment requirements and other barriers to entry mean that, for now, wealthier individuals are expected to benefit most from this trend.
Listed companies represent only a small fraction of the registered companies around the world while borrowing from bond markets is only open to firms of a decent size.
Investing in private equity and private credit can increase opportunities to enhance portfolio performance. Meanwhile, financial innovation and the needs of private capital have also opened a new set of investment opportunities.
Those structural changes, coupled with higher volatility in public markets, have fuelled investments in these ‘alternative’ investments. Assets under management rose from US$2 trillion in 2003 to US$25 trillion in 2023. One estimate sees this market hitting US$59 trillion by 2033.
How is investing in private markets changing?
Traditionally, private market investments were the domain of large institutional investors due to high minimum commitments and long-term investment horizons.However, this is changing. Innovations in financial technology and regulatory changes have made it easier for a broader range of investors to participate.
Additionally, there has been a growing trend towards ‘evergreen’ funds and semi-liquid pooled investment vehicles that offer investors more dealing flexibility with regards to commitments and withdrawals, compared to traditional private market vehicles.
That said, still-sizeable investment requirements and other barriers to entry mean that, for now, wealthier individuals are expected to benefit most from this trend.
Why private markets?
- Diversification, reduced correlation. One of the primary advantages of private markets is their ability to provide diversification. Private market assets have a low correlation with traditional equities and bonds (see Chart 1). This means they do not necessarily move in tandem with public markets, thereby reducing overall portfolio volatility and improving portfolio resilience. For example, infrastructure assets – such as energy generation and transportation – often have long-term government-backed contracts that provide stable cash flows, even during economic downturns.
Chart 1: Public vs private markets, correlation
- Enhanced returns. Private market investments have historically offered higher returns compared to their public market equivalents due to the ‘illiquidity premium’ – investors are compensated for the lack of liquidity with higher potential returns. Our research has shown that the illiquidity premium can add some 2%-4% a year to private equity returns over the long run. Private equity investments in growth companies or buyout transactions can yield substantial returns through strategic management and operational improvements.
- Inflation protection, stable cash flows. Certain private market assets, such as infrastructure and real estate, provide a natural hedge against inflation. These assets often have contracts or leases linked to inflation, ensuring that cash flows increase with rising prices. This makes them particularly attractive in periods of high inflation, as they can help preserve purchasing power. Additionally, private credit investments offer stable and predictable cash flows through interest payments, further enhancing portfolio stability.
- Access to unique opportunities, value creation. Private markets offer access to unique investment opportunities that are not always available in public markets. This includes investments in niche sectors, emerging markets and innovative projects. For instance, private equity funds can invest in early-stage companies with high growth potential, while infrastructure funds can finance critical projects like renewable energy and smart cities. These investments not only provide financial returns but may also contribute to social and environmental goals.
- Risk management and resilience. Incorporating private markets into an investment portfolio can enhance resilience against market shocks. The dynamic nature of private investments, which often involve active management, allows for strategic value creation. For example, private market managers can implement operational improvements, cost efficiencies and strategic acquisitions to enhance the value of their investments.
And the risks?
While private markets offer many benefits, they also come with risks. They are inherently illiquid, making it challenging to sell investments quickly. This can be mitigated by maintaining a diversified portfolio and having a well-planned cash management strategy.Meanwhile, valuing private market assets can be difficult due to limited transparency and data availability. Using robust valuation models and regularly updating them can help.
Potential investors need to be aware of the different level of risks their portfolio is exposed to. This ranges from thematic risks, such as geopolitics or technology advancements, to idiosyncratic risks – including management quality, governance structures and operational risks. Other risks may relate to macro, market and private capital factors.
Thorough due diligence and ongoing monitoring of investments are critical. This needs to be tailored to the means of investing – via fund commitments, co-investments or direct investments – as well as to different asset classes.
Picking the right manager is important as the dispersion of returns among private market fund managers is significantly greater than the best and the worst performers in public markets (see Chart 2).
Chart 2: Public vs private markets, 10-year returns
Using scenario stress testing and a comprehensive risk management framework can help address risk exposures and changes in valuations within portfolios.
But private markets stand out as a potential shock absorber for some portfolios - helping investors mitigate volatility and achieve long-term returns.
While these investments require careful consideration, they also offer benefits that can complement traditional portfolios.
Investors should weigh liquidity needs and risk tolerance before committing. But for those with access and patience, private markets may offer a pathway to stability and growth – even in turbulent times.
Final thoughts
Amid the shockwaves emanating almost daily from Washington, equity markets look vulnerable to further tumbles, while global bond markets look shaky as interest-rate expectations shift.But private markets stand out as a potential shock absorber for some portfolios - helping investors mitigate volatility and achieve long-term returns.
While these investments require careful consideration, they also offer benefits that can complement traditional portfolios.
Investors should weigh liquidity needs and risk tolerance before committing. But for those with access and patience, private markets may offer a pathway to stability and growth – even in turbulent times.