Private markets are traditionally illiquid, harder to access and less transparent than public markets. But despite these characteristics, private equity as an asset class has experienced significant growth over the past 30 years, becoming a £8trn juggernaut.
The early 1990s saw investors in US listed equities spoilt for choice, with over 8,000 companies available. Today this number has dwindled to nearly 4,500. Similarly, in the UK, the number of listed companies has fallen by roughly 40% since 2007.
Today’s investors face an extraordinary degree of equity market concentration, with a mere 10 companies accounting for nearly 20% of the MSCI All Countries World index.
Consequently, opportunities for genuine diversification and long-term growth from industries of the future are becoming scarcer in listed markets. Against this backdrop, private markets have diversified and evolved.
Does private equity do it differently?
The returns from unlisted and listed equities flow from the same source: economic growth leading to profit growth and creation of enterprise value. From an absolute return perspective, one might expect both investments should, on average, perform similarly.
However, private markets managers cite several factors enabling private market investments to achieve higher returns than equivalent listed opportunities. A shortlist of these includes early access to high-growth companies, ability to improve private companies’ operational efficiency, better access to capital and the ability to focus on long-term objectives.
Various studies have investigated whether these factors can be directly linked to returns. An essential takeaway is that each private equity manager and vintage will show different biases resulting in a very wide range of returns.
So, it is difficult to make generalisations that apply across private markets investments and vintages.
How big is the illiquidity premium?
Anyone who invests in private equity must be prepared to have their capital tied up for multiple years. In exchange, investors naturally expect to receive an illiquidity premium. Indeed, whether a private equity illiquidity premium exists once fees and other costs are accounted for is the subject of lively debate.
Historically, it has been difficult to find private markets returns that are relevant and easy to compare with other asset classes. However, the increasing transparency of private equity, and the availability of better measures of performance such as Public Market Equivalent, enable investors to make absolute and relative judgements.
Notably, a recent independent study by CEM Benchmarking of 200 public and private sector pension funds between 1998-2021, which compared gross returns, found that private equity has produced a significant illiquidity premium relative to listed equities. Of course, gross returns are not what an investor receives and the costs incurred when embracing private assets are very significant – they effectively halve the net average return. Despite this, real returns have been 1.7% to 3.9% per annum higher than similar listed market equities, equating to a premium of 18% to 56%.
How liquid are private assets?
Over the past decade, the significant growth in secondary markets for funds of private assets has improved liquidity. However, secondary market prices in the current market cycle are at discounts to net asset value. For good-quality buyout assets, these discounts are around 7% to 10%, with riskier or longer-duration assets often at 25% to 50% discounts. While secondary private markets can provide liquidity, they often cannot be realised at their full value until they wind up. Therefore, they should also be considered illiquid.
A second key liquidity consideration is the pattern of cash flows when investing in private equity. When a private equity fund launches, investors commit their first instalment of capital. As investments are realised, capital starts to be returned to investors and when all investments have been exited, the fund winds up.
After a reasonable length of time, typically five to seven years, further capital calls can be covered by the return of capital from investments made in prior years, thus maintaining a relatively neutral cash flow.
However, demand for fresh capital can exceed the returns. This is particularly likely if private asset valuations are depressed. Managers will not wish to sell existing holdings to invest in new assets at depressed levels and may require investors to commit further capital. Therefore, it is essential investors consider private markets as illiquid and avoid relying on hopeful shortcuts to realise gains or meet cash flow demands.
Making an allocation to private markets is not a straightforward decision. The range of returns between managers and the importance of identifying and accessing the best managers should not be underestimated, nor should the implications of holding illiquid assets.
Richard Maitland is senior partner at Sarasin & Partners