Is illiquidity such a bad thing?
Committing capital to a private market investment for five or ten years can feel uncomfortable. But it may come with benefits - and play to your advantage as a private investor.
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In August 2024, stock markets around the world suffered their sharpest falls in years, in response to disappointing employment data from the US and a slightly larger-than-expected interest rate increase in Japan. It’s just one example of how markets can and do overreact. Since then, share prices have recovered strongly, but investors who succumbed to the panicked mood and sold out would have missed the rebound. Sitting tight through this episode would have led to a better outcome.
For some investors, this is part of the appeal of investing in private assets, whether this is private equity, venture capital, renewables or infrastructure. These asset classes are generally accessed through vehicles that require a long-term commitment of capital (over five years). They may only be revalued on a quarterly basis and, as a result, are less likely to be subject to such frequent swings in reported value.
Private assets aren’t suitable for everyone. Investors need to carefully assess whether they will need access to the capital during the term of the investment. Even sophisticated investors can get this wrong. During the UK’s 2022 “mini-budget” crisis, for example, bond market losses forced many pension funds to sell out of private equity investments. Given the rush for the exits, many were sold at discounts to fair value, highlighting the risk of misjudging liquidity requirements.
In our experience, however, many high-net-worth individuals and families actually can lock up capital for the longer term. Often, they are able to set aside funds for future generations without any need to draw on income or capital. They are also likely to face fewer regulatory restrictions than institutional investors. This flexibility constitutes an advantage over many other kinds of investors – and it makes sense to use it.
Long-term alignment of interests
Historically, private markets have delivered higher returns than public markets ones (source: PitchBook, as at 31 December 2023). Academics describe this phenomenon as the “illiquidity premium.” But how does it work in practice? These higher returns reflect the long-term performance of individual asset classes and are not a function of investors’ behaviour. In other words, there may be inherent features in how these assets are owned and managed that drives the higher returns.
One common characteristic of illiquid assets is that they are not held by large numbers of investors. In many cases, this allows for a greater alignment of interest between owners and managers. This is one explanation of higher returns. The management of a public company needs to reflect the expectations of a wide range of shareholders, some of whom will want to see higher profits every quarter. In a closely-held business, it may well be easier to secure support for strategies that prioritise long-term value creation over hitting short-term targets.
There are other advantages associated with private markets. Many managers can combine deep sector expertise with access to significant capital. This may put them in a far stronger position to restructure or make acquisitions than standalone public companies. This can in turn transform the growth and / or profitability of a business, helping generate higher returns over the long term. This is often described as the “complexity premium,” reflecting the expertise required to execute complex investments in private markets.
A more diversified portfolio
Private markets have evolved significantly over the past twenty years. They now encompass huge areas of economic activity, many of which are key drivers of long-term growth, such as renewable energy and infrastructure. These areas can often be accessed through public markets, often in the form of listed investment funds. However, these vehicles can come with other challenges and may offer a far more limited opportunity set than unlisted funds.
In the corporate world, privately-owned businesses account for a significant share of the overall market. Blackstone, the large alternative asset manager, estimates that nearly 90% of US companies with revenues greater than $250m are privately-owned (as of November 2023), and that 64% of global corporate revenues come from private businesses.
This reflects two trends. Firstly, the huge amounts of capital raised by private equity firms means that we are seeing very substantial businesses being taken private – such as the UK supermarket chain Morrisons or Japan’s Toshiba. Secondly, there is a well-established trend of fast-growing technology companies remaining private for far longer than used to be the case. Companies such as Facebook and Uber were already very big businesses by the time they floated, and the largest gains were made by investors who owned them before they went public. Others, such as SpaceX, remain private despite being valued at over $100bn. Investors who limit themselves to public markets may be missing out on the next crop of innovative companies.
This is especially important today. Many stock markets are very concentrated with a handful of large companies driving performance. This is particularly apparent in the US, with the “Magnificent 7” technology stocks dominating the S&P500. But it is also a feature of other regions, such as the UK, where the largest companies account for a high percentage of the stock market’s total value.
All of this means that private assets can be very effectively used to diversify portfolios and manage risk. In many private markets, the pattern of returns looks very different from public markets – and from other private markets. For example, at a time when public equity markets are under pressure due to slower economic growth, an infrastructure investment may continue to generate stable cashflows, smoothing the performance of a portfolio. Similarly, the performance of a venture capital investment is likely to be far more dependent on the technology cycle than changes in the rate of GDP growth.
Don’t fear illiquidity
Investing in private markets is a long-term commitment. This requires careful thought not just about your financial position today, but how it will evolve over the coming years. You will also need to think about how you fund payments required to meet commitments. However, where it is suitable, there are significant benefits to investing in private markets, including the potential for higher returns and greater diversification. In practice, making a long-term commitment can also help investors avoid knee-jerk decisions that lead to poor investment outcomes.
Risk warning - Private Assets: Investors should only invest in private assets (and other illiquid and high risk assets) if they are prepared and have the ability to sustain a total loss of their investment. No representation has been or can be made as to the future performance of these investments. Whilst investment in private assets can offer the potential of higher than average returns, it also involves a corresponding higher degree of risk and is only considered appropriate for sophisticated investors who can understand, evaluate and afford to take that risk. Private Assets are more illiquid than other types of investments and harder to sell. Investors may well not be able to realise their investment prior to the relevant exit dates.
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This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.
This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.
All data contained within this document is sourced from Cazenove Capital unless otherwise stated.
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