There has been a rising trend of wealth managers focusing on private market investments, capturing superior returns in compensation for lower liquidity. They remain the ultimate exemplars of active investing, given the need to closely manage portfolios. The author asks if the sector will eventually overtake listed stocks.
A steady theme in these pages over recent years has been how high net worth clients are increasingly urged to hold private market investments, such as private equity and venture capital, private credit, forms of property and infrastructure. Since peaking in size in the dotcom era of the 1990s, public listed markets have been in structural decline. This is blamed on several forces. Regulations such as the US Sarbanes-Oxley accounting rules have inflated the compliance burdens of being a public company. Private firms also don’t have to adhere to those annoying quarterly reporting schedules, with lots of shareholders demanding more dividends, break-ups or sackings of management. Another source of attraction for private investments is that they are typically less liquid. To compensate, they offer superior returns.
To discuss all these issues is Gareth Lewis, who is chief executive of Delio, a UK-based fintech firm. The editors are pleased to share these views; the customary editorial disclaimers apply. Jump into the debate! Email firstname.lastname@example.org
The importance of private markets has grown significantly for investors and institutions over the last decade, largely because the performance of this asset class versus more traditional investment markets has excelled.
Private equity provided a pooled IRR of 27 per cent last year, according to McKinsey’s Private Markets Annual Review. With this level of performance, especially in what is now a relatively high inflationary environment, it is little wonder that there is rising interest in alternative assets.
In fact, according to the EY 2021 Global Wealth Research Report, 42 per cent of investors are considering increasing their holding of alternative assets in their portfolio, a figure which is up from 37 per cent in 2019. One in three clients already has alternative assets in their portfolio and this level is expected to rise to 48 per cent by 2024.
This rebalancing of portfolios would seem like a sensible option for the right investors given that private equity continues to outperform its public counterparts. A Kaplan-Schoar PME analysis outlined in the same McKinsey report, where Burgiss considered the Global PE funds versus MSCI World Total Return Index, showed that private equity funds in 2008 to 2018 vintages had outperformed the public market equivalent by 1.17 times. Only the median fund of the 2008 vintage failed to outperform public markets.
Growing asset class
Across all asset classes, private markets have grown to around five times the level they were at back in 2007. Over the same period, public markets have seen two times growth. Of course, the absolute value of investment in each is vastly different – public markets represent around $125 trillion of capital compared with $9.8 trillion of private market capital. It is always going to be difficult to grow a higher-capital value by a greater multiple. But that doesn’t remove the impressive acceleration of alternative assets.
This pace of growth is expected to continue for the next five years as access to private markets becomes easier, the investment universe becomes bigger, and more investors gain a better understanding of alternative asset classes.
Regulatory oversight increasing
Investors are not the only ones taking more notice of alternative assets; international regulators have also increased their focus on this area.
This is positive news for investors as it should create more confidence because private markets are subject to the same level of governance as their public counterparts. Some regulators, such as the SEC in the US, are also relaxing criteria for investor classifications which will widen access further.
As greater amounts of capital are allocated to alternative assets, it is inevitable that regulators will take more interest in the space. This does mean that financial institutions offering their clients access to private markets need to act now to ensure that their regulatory frameworks are robust and compliance processes are transparently documented.
The digitisation of these operating models is playing a key role in how firms tackle the unique complexities associated with private markets. Technology not only helps to improve regulatory compliance, but also increases the number of deals that can be distributed to a wider number of potential investors.
This in turn creates a greater need for firms to be able to demonstrate that their operating model stands up to the expected rise in regulatory scrutiny in the coming months and years. They must ensure that their sales processes are robust, well documented and auditable, otherwise we could see a future mis-selling scandal which no-one in the industry would benefit from.
Increasing comfort for investors
As regulatory oversight increases and the level of investor comfort rises, the number of people seeking access to these alternative assets will also rise. Consequently, these investments will become more mainstream, which will inevitably close the gap between private market and publicly-listed investments.
An ongoing consultation from the UK’s Financial Conduct Authority on Long-Term Asset Funds being marketed to a wider group of retail investors and schemes in the future is likely to accelerate this still further. The proposals currently out for consideration would provide access to non-traditional investments that could be used by retail investors to diversify their portfolio in the search for higher returns, while still benefiting from strong consumer protection. The FCA is asking for feedback on the proposals by 10 October 2022, with rules expected to be confirmed early next year.
These changes will help to facilitate capital flow not only from institutional investors which have typically had access for many years, but also to a growing number of mass affluent investors.
However – or perhaps more accurately, especially with increased regulatory oversight – it is vital that these investments are offered to investors who are sufficiently wealthy and experienced in order to prevent future mis-selling issues. These concerns can be reduced through the use of technology to not only collate and present deals that are appropriate for an investor’s profile, but also to ensure a fully tracked, end-to-end regulatory process.
The gap is closing
So, will private markets overtake public markets? Well, it is highly unlikely in pure monetary terms, but we are going to see the gap between the two close – and the speed of that closure will accelerate over the next five years. The current split between public and private investments is around 90 per cent to 10 per cent, and we are likely to see this shift towards perhaps 80 per cent to 20 per cent in the coming years. This significant change in investor sentiment represents a massive opportunity for those institutions offering their clients access to private markets.
Public markets are already mature in the key, fundamental market characteristics – well known, easily tradable, and with little real friction as there are so many firms operating in the broking and market-making space for these products. There are also a lot of retail-focused apps designed to encourage investors to enter these sectors, with mature regulatory frameworks for market conduct, among other factors.
Yet private markets are moving towards the public market’s core fundamental infrastructure, which will naturally also encourage more capital into this space over time. The returns we have seen in the recent past, while not a guide to the future performance, give an indication of what is possible. With inflation at levels not seen in more than 40 years, investors will be searching for ways to make their investments and income keep pace with inflation, so that their buying power is not diminished.
The question is which associated pull/push factors will come into play most strongly to increase the proportion of alternative asset investments held in more portfolios. If we continue to see such strong returns from these assets going forwards, there is no reason why they won’t become even more popular, especially once they are more closely regulated.
About the author
Gareth Lewis is CEO of Delio, a UK-based fintech operating across Europe, North America, Asia and Australia. Its technology helps financial institutions to connect their clients with private investment opportunities quickly, transparently and compliantly. From international private banks to wealth managers and angel networks, Delio serves over 90 financial institutions. More than $26 billion-worth of investment opportunities are currently shared across Delio-powered platforms.