By Simon Tryzna, CFA, Chief Investment Officer
One of the biggest trends of 2021 has been the rise of private investments. At the moment, we are in the midst of a historical shift between the roles of public and private markets. On the private equity side, there has been a long-term secular decline in public ownership of companies. Because of the restrictions imposed after the 2008 Great Financial Crisis, banks can no longer provide loans to several businesses, creating an opportunity for private credit investors to tap into a new market. And given that a real estate investment thesis takes years to play out, private real estate can lead to better long-term returns than publicly-traded REITs. Lastly, because of the inefficiencies of the private markets, skilled investors can generate higher expected returns for the same amount of risk than in the public markets.
The first alternative investment was the U.S. Transcontinental Railway, financed in part by private capital that received subsidies via the Pacific Railroad Act of 1862. A few decades later, in 1901, J.P. Morgan (the banker, not the bank) helped Federal Steel Co. facilitate the acquisition of Andrew Carnegie's Carnegie Steel Co. This was the first leveraged buyout, a precursor to modern private equity, and created the United States Steel Co.
A private investment can be defined as an investment in a non-publicly traded security through a negotiated private transaction. The details between buyers and sellers are not publicly disclosed, and most private transactions involve companies that are not publicly traded. Because investments are made in private, skillful managers can often source deals without needing to into a "bidding" war and can often underwrite an investment at a valuation that they feel is attractive.
Present-day, large university endowments and pension plans have sizeable allocations to private alternative investments.
The underlying investment thesis focuses on three things:
- Enhancing returns by accessing different sources of returns
- Diversifying the risk through lower correlations to traditional, publicly traded securities
- Supplementing income by casting a wider net for yield-oriented investments.
Below I'll touch upon the three main asset classes – private equity, private credit, and private real estate. Within each of the broader asset classes, there are different sub-asset classes, which could provide opportunities for even more diversification within a private alternatives portfolio.
Private equity, in short, is equity investments in non publicly traded companies. Whereas around 6,000 companies are trading on the NYSE and NASDAQ today, there are over 1.9 million private-sector firms with over 50 employees (per BlackRock).
Because private companies aren't legally required to disclose financial information, the private market is highly inefficient. It allows for skilled investors to take equity stakes in businesses, improve the fundamentals, and make the company more attractive for new investors. They can sell the company to a conglomerate or take it public.
Private companies are also not evaluated on a quarterly basis, which means they can focus on longer-term vision and strategy execution rather than appeasing investors with a short-term mindset. Due to the combination of those two factors, private equity has historically outperformed publicly traded companies (chart courtesy of BlackRock):
Over the last decade, companies have elected to stay private for longer and, on aggregate, more growth before they went public. Because of the size and the inefficiencies of the private markets, this has become an incredibly attractive investment opportunity when combined with the rich valuations of the public markets.
Different types of private equity include buyout (taking a public company private), growth, venture, distressed / turnaround.
Historically, a private company in need of capital would typically borrow it from a mainstream bank. After the Global Financial Crisis (GFC) of 2008, U.S. regulators – seeking to avoid what led to the GFC in the first place – restricted how much money mainstream banks could lend to companies. Private Credit funds, particularly those that specialize in direct lending, helped fill that void. Small and medium enterprises now go directly to middle-market lenders because they get turned away from banks.
In return, private credit lenders can demand favorable terms to offset the loan risk and provide a higher-yielding investment opportunity to the end investor than what they would be able to find in the public debt markets.
The other sizeable private credit sub-asset class is distressed debt investing. In this instance, the fund purchases cheap debt of a company in need of restructuring and looks to work with a private equity firm (or do it on their own) to improve the company's standing and thus the value of the debt they own. The long-term investment thesis helps investors, as these types of deals require time to be worked through. Because of that, investors receive extra compensation, both in yield and the price appreciation of the underlying.
Private Real Estate
Private Real Estate is a popular investment for investors seeking access to alternative sources of income and growth and to an asset class that's less correlated to equities and bonds. Like Private Equity & Private Credit, Private real estate has multiple sub-areas within it: multi-family housing, industrial, office, hotel, and retail.
Real Estate Investors can profit from multiple sources of return –
- Property value can increase, which is captured on the sale of the property (profit income)
- Property owners can collect payment from tenants (earned income)
Increased rent (which increases income) may help private real estate owners keep pace with rising inflation, which helps preserve the purchasing power of those dollars in real terms. Additionally, higher inflation typically occurs during times of economic growth, in which property owners can generally find tenants more quickly, which also helps drive property values higher.
Because private real estate assets are valued infrequently, volatility remains low and helps provide portfolios with improved risk-adjusted returns. Real estate investments have also performed well during periods of the highest inflation in the U.S, making this asset class even more attractive in the current economic environment.
Risks & Considerations
The biggest risk, as with any investment, is loss of capital. Aside from that, the other important aspect of private investments to consider is the investment's time horizon and when the investor can expect to get their return of capital. Because of the lock-up period, private funds may not be required to return investors' capital for as long as ten years they provide an "Illiquidity Premium." Investors in private funds are compensated for "locking up" their money by having an extra level of returns.
Because of the capital call nature of private funds, not all committed capital may be called, and there may be infrequent timing of calls. Because of that, investors need to make sure they have committed capital liquid and are ready to be wired out to fulfill the call obligation. Some funds have an option to have the investment life be extended if the fund manager thinks its best, so the target return of capital may be longer than anticipated. Capital will be distributed throughout the investment process - this could be proceeds from a sale of an investment or interest/rent payments (or any other cash flows passed through to the LPs).
With the evolution in tech, companies have now been able to scale their operations and offer lower minimum investment level private investment funds. This development has now opened a new opportunity set for many who haven't been provided this type of investments before. With a lot of tailwinds in the private investment space and many valuation issues in the traditional public domain, private investments merit a lot of consideration for investors who can allocate 10-20% of their liquid portfolio to one comprised of private funds.