Private markets have grown strongly in recent years, with a resultant increase in media attention. What are the advantages and disadvantages of investing in these markets and what role should they play, if any, in your portfolio?
Overview:
Private markets, sometimes described as unlisted or non-public markets, play a significant and growing role in global financial systems and frequently prompt questions from our clients about whether these sorts of investments should feature in their portfolios.
Private equity, venture capital, private debt, real estate, infrastructure and private placements are just some of the assets and investment vehicles classified as private markets, or those not traded on public exchanges.
These sorts of vehicles are a valid asset class, offering diversification benefits, potential tax savings and the opportunity to earn higher returns. But they also come with specific risks, such as illiquidity, intermittent availability, high minimums and higher costs. As well, some private market investments can be overly engineered, complex and opaque.
As such, we believe that before entering these markets, investors should employ a disciplined, clearly thought-out process that takes account of their own goals, temperaments, financial capacity and clear understanding of the risks involved.
In this, we recommend clients adhere to the broad philosophy we apply in public markets to construct their portfolios. That means getting as close as possible to the underlying asset classes that drive returns and keeping the layers of fee-taking agents to a minimum.
The risk of not following this approach is that investors, initially seduced by the promise of higher returns, end up having an experience they did not count on and that leaves them in the dark with no income for long periods, no transparency and little sense of control.
Below, we detail the strict process that Minchin Moore employs in considering the suitability of private markets for clients and whether these alternative investments offer any benefits above what they can get from highly liquid and efficient public markets.
But first, some background on the nature, growth and features of this asset class:
Growth
Over the past few decades, private markets have grown substantially. According to McKinsey, private assets under management globally totalled just over $US13 trillion in mid-2023, having grown by 20% per annum in five years.
The global private equity market alone, including buyout and venture capital vehicles, accounted for about half that sum.
What is driving this growth? On the supply side, one major element has been the increasing number of companies choosing to remain private longer. In previous decades, companies often sought initial public offerings (IPOs) early in their life cycle to access capital.
Today, many firms, particularly in the technology sector, opt to raise capital in private markets, where they can often find more patient investors and avoid the regulatory and reporting burdens associated with being publicly listed.
On the demand side, the rise of institutional investors, such as superannuation funds, sovereign wealth funds, and endowments, has also contributed. These investors have increasingly allocated capital to private markets in search of higher returns and diversification benefits, driven by the low-interest-rate environment that persisted for much of the past decade. Private markets have offered opportunities for higher yields compared to traditional asset classes like bonds and publicly traded equities.
Differences Between Private and Public Markets
A fundamental distinction between private and public markets is accessibility. Public markets, such as stock exchanges, provide broad access to investors of all types, from retail to institutional. Shares of publicly listed companies and other securities are bought and sold on exchanges with relatively high liquidity and transparency, allowing investors to quickly enter or exit positions.
The regulatory framework governing public markets, established by agencies like the Australian Securities Commission, is designed to protect investors by ensuring that companies disclose key financial and operational information in real time.
In contrast, private markets operate with much less transparency and are generally available only to accredited investors—those who meet certain financial thresholds that indicate a capacity to assume the risk associated with less liquid and more opaque investments.
Securities in private markets are not traded on exchanges but are instead sold directly between parties, often through private negotiations. This lack of liquidity means that investors in private markets typically must commit their capital for longer periods, sometimes up to 10 years or more, particularly in private equity or venture capital funds.
Another key difference is valuation. In public markets, asset prices are continuously updated based on supply and demand dynamics, making valuation straightforward for most securities. Private markets, by contrast, rely on less frequent valuations. This is because transactions are less common, and private companies do not have to report earnings on a quarterly or half-yearly basis, meaning investors often must rely on estimates from fund managers or independent appraisers to determine the value of their holdings.
Private markets also allow for greater flexibility in structuring deals. Investors and private companies can negotiate the terms of their investments, including covenants, repayment schedules, and control rights. In public markets, securities like stocks or bonds typically come with standard terms, and individual investors have little room to negotiate. This flexibility in private markets can be both an advantage and a disadvantage—it allows for tailored investments but also introduces complexity and the potential for misalignment of interests between investors and companies.
Considerations for Investors
As with any investment choice, investors should weigh the benefits and risks of private markets in relation to their own goals.
Potential benefits include diversification. Private markets can offer investors opportunities in addition to those available from traditional asset classes like stocks and bonds.
There is also the potential to significantly enhance returns compared with public investment because of the premium offered in return for low liquidity and long lock-up periods. As well, some managers of private assets have demonstrated a track record for adding ‘alpha’, or a return over and above that available from traditional investments.
Another potential benefit is tax saving. ‘Early-Stage Venture Capital Limited Partnerships’ (ESVCLPs) are a vehicle for achieving such an outcome. These are tax-exempt partnerships, with flow-through tax-free status for investors.
But these benefits are also offset by specific risks. The illiquidity of private investments means they are inflexible, making it harder to rebalance individual investors’ portfolios and successfully timing their cashflows.
There are also usually minimum investment hurdles with private assets, commonly above $500,000, and it may take some time to become fully invested. Costs can also be substantial. A typical manager charges a 2% fee on committed capital, plus a performance fee of 20%.
Moreover, there are the additional risks that come with active management, which introduces illiquidity risk, transparency risk, pricing risk and the idiosyncrasies of the individual manager running the fund.
Even so, for some sophisticated investors an allocation to private markets may be appropriate. Minchin Moore looks at several considerations here, including financial capacity and acumen, temperament and the experience of each investor.
Building a private markets component within a client portfolio requires a disciplined approach to diversification and implementation, including requirements on the number of funds, companies per fund and manager relationships.
To ensure a regular flow of capital calls and capital returns, vintages are spread over several years. The typical fund term is 6-10 years and the aim is to fully deploy allocated capital over three years.
We adopt a long-term, top-down and strategic approach to constructing a private markets portfolio for clients – one that is consistent with our philosophy with public markets. This contrasts with the often opportunistic, short-term approach that is sold to many high net-worth investors by institutions who may be dazzled by the latest fashion and fads.
Summary
Private markets have grown strongly in recent years as recipient firms look for patient capital and investors seek to diversify away from traditional listed markets.
But these private markets are not suitable for everyone. The potential additional return, diversification and tax benefits must be set against the loss of liquidity, transparency, high hurdle rates for entry and significant costs.
Investors need to ensure they have sufficient liquidity elsewhere in their portfolios to cover any cash flow needs during the lock-up period. The higher expected returns of private markets are the reward for bearing that liquidity risk and being exposed to smaller, often riskier companies with less ready access to capital.
The absence of daily market price updates can make private assets seem less volatile than public ones, but this is often more a reflection of infrequent pricing rather than actual lower risk. Investors must carefully consider the underlying risks, such as economic downturns, sector-specific issues, or even changes in government policy, which could have a disproportionate effect on private investments.
In short, the investor’s journey in private markets can be significantly different to what is available from mainstream investments. In private equity and venture capital funds, for instance, investors must learn to live with no income for anywhere up to 10 years and can discover with some exasperation that they have little clue about what their investment is worth because of long blackout periods.
With all that in mind, private markets can offer unique opportunities for investors willing to accept the trade-offs of reduced liquidity, higher risk, and less transparency in exchange for potentially higher returns and portfolio diversification.
However, investors need to have confidence that the returns after fees will exceed what is available at much lower cost and greater transparency in public markets. And they need to be steered by an adviser who adopts a long-term, strategic and top-down approach that employs the same broad philosophy that guides their investments in public markets.
As always, helping you balance these risks and benefits, and keeping all your investments consistent with your chosen strategy, is the benefit of having access to a professional, independent adviser who knows you, your circumstances, goals and risk appetite, and who follows a clear process to ensure your portfolio gets you to where you want to go.
Global Private Markets Review, 2024, McKinsey, March 28, 2024
