Private Markets: Round 2
I've written previously on private markets and the challenges they pose for individual investors. The more I think about it the more it doesn't sit comfortably with me, especially when we're talking retail & wholesale investors. Once again, these comments are from a personal wealth perspective, not institutional.
This article speaks to open-ended "evergreen" vehicles rather than closed ended PE Funds under a capital call structure. And this is more about a commentary on direction (proliferation of vehicles) rather than what exists in the market, we're in the middle of a flood.
A Solution in Search of a Problem
I still get the feeling that this is a solution for a problem that doesn't exist.
Very cynically, passive investing has killed the economic model for most fund managers, and they must find a solution for viability & profitability. Fund manager incentives today:
- Passive investing has significantly eroded active management margins
- Public equities active managers could charge let's call it 70-80bps
- We've seen industry super pull mandates and asset consultants grind fees lower
- Private market asset management charge let's call it 200-250bps
- Private credit funds that have changed hands in public markets showing around 300bps of fees
- Fund managers only need to raise 30c in the dollar to get to the same/similar economics by moving from public to private markets
This fundamentally changes the sales incentive model - suddenly everyone "needs" private market exposure. Suddenly it's not about returns and access becomes the product.
And then I hear many from the buyside within the wealth industry (consultants, HNW advisers, CIOs) parrot this view - really?
Fees
Can you see why private market managers love this stuff? Instead of getting paid your performance fee on exit (ie traditional funds), you can get paid along the way now. Democratisation of private markets for all!
Public markets - there is a clearing price, we know what it is and I'm supportive of performance fee economics for some parts of public markets (ie small caps). I like it.
Private markets - Closed ended PE performance fee structure is the gold standard - the manager only gets to collect performance fees upon exits and realisations. So good, incentive to get my money back and perfectly aligned to my net outcome. I love it.
Private markets, democratised - Open ended vehicles, private assets with no clearing market get marked up in price. What is appropriate as a valuation? I have no idea. And a manager gets paid a performance fee on this? Mark your own homework and collect your fee. Yuck.
"Public Markets Are Shrinking"
The main argument everyone seems to be latching on is that the IPO market is dead and therefore, the opportunity set for public markets is smaller than private markets - so you need a greater pool of assets to invest in to generate returns.
Bullshit.
Okay yes, public markets have contracted recently, but this comes after a period of over-exuberant listings between 2020-22. The number of listed companies on the ASX and NYSE is still higher than it was a decade ago.
The IPO market is inherently cyclical. It slowed/was non-existent, but it is turning again. Either way, the opportunity set for scalable investments in public markets has narrowed but not disappeared.
(There is a whole other comment here on the level of concentration you end up with some private markets funds - sure the universe is bigger, but investors only ever get exposure to a very small sleeve of this)
Overvalued Assets & IPOs
At the start of my career one of the main things I couldn't quite get my head around with private markets was how exits work, that an IPO isn't necessary and instead many funds ended up selling to other private market funds or undertake strategic M&A or sell to other private companies.
But the IPO is an important avenue regardless and the real reason we aren't seeing many IPOs today is because post-2019 vintage private assets are overvalued.
Companies raised money at aggressive multiples. Add leverage, rising rates, and operating margin compression - and you've got a double squeeze. Public markets corrected their valuations through 2022 as the double squeeze due to higher rates and higher implicit cost of capital caused a reset in public market valuations. A "valuation recession".
Public market valuations reset. Private markets didn't (or at least as quickly).
Primary markets today are well and truly open, companies are getting capital raises away easily, IPOs are well and truly oversubscribed, and the ultimate test is always new LICs & LITs which are all getting away with plenty of broker interest. We should see more IPOs come to market after Aug/Sep once private companies lodge their FY25 returns.
This is probably good for private asset managers (any pre-IPO funds still left standing?)
Fit For Purpose
Private assets are an excellent solution for certain parts of the market - ie multi-billion dollar institutional vehicle that can only hold so much CBA.
Let's take industry super for example, scale constraint public market exposure and need long-duration assets to match liabilities - private markets a great way to build exposure and also benefit from governance and control through direct ownership.
But once again if you're reading this, I'm more interested in addressing allocating your personal capital (under $100m) with what I write so this is likely relevant for you personally. And you can probably invest in micro or small caps (where markets are most inefficient) or real estate (where you get the benefit of a tax break that institutions cannot access).
I also think that as individuals, it is difficult to access the opportunity for material non-public information to be utilised effectively - which it can be through private markets - a view I don't think enough people recognise as a source of alpha that requires unique human capital to monetise (no insider trading laws for private markets!)
Don't Rush
My joke now is that all the value investors have ended up in private markets today.
As I said earlier, I am a big fan of private markets, but the rapid proliferation of private market assets over the last 18 months makes me say, pump the breaks a little bit, you're not going to go broke by not allocating there tomorrow. Are you doing this because of "diversification" or is this more about reducing your apparent mark-to-market risk? Diversification or feel good?
Think this through properly, what is fit for purpose?