Over the next few years, individual investors are expected to put more money into private markets than almost every type of institutional investor.
The compelling return history for private market investment is clearly a key motivator for these allocations. Schroders Capital research shows this is the main reason institutional investors enter private markets, and we have no reason to believe individual investors think any differently.
Until recently, though, access has been limited for smaller investors. The ongoing “democratisation” of private vehicles is whittling away at the access hurdles. Today, retail investors comprise around 30% of private asset ownership and, while it’s unlikely the gap to institutional ownership will close entirely, we expect it to narrow significantly over time.
Of course, returns aren’t the only reason to use private assets, even if it’s high on the client agenda. Characteristics like stable income and genuine diversification add to the appeal. Overall, more and more investors are being won over by the argument for a private markets allocation.
Once the decision to allocate to the asset class has been made – what next? How do investors actually start their private assets journey, and what can they expect the journey to look like?
Pacing is different
One of the key differences with private asset investment is in the pacing of capital deployment. With no readily available secondary market to provide liquidity, allocations can and should be structured to, in a sense, create their own liquidity. Structured correctly, private asset allocations can become “self-sustaining”. What does that mean?
Many private assets vehicles – there are exceptions – raise capital every year in what are known as “vintages”. Each vintage represents a discrete fund that has an investment phase and a harvesting phase. The investment phase is when the capital is put to work, typically over a period of about 3-5 years depending on which part of the private assets market it’s in, and what the market backdrop is like. The harvesting phase is when the invested assets are exited. This is typically around 5-7 years after the investment is first made. In private equity, the exits will be from portfolio companies themselves.
Private equity managers will use the term “exits” because while selling an asset is an option, it’s only one of many options available. The routes to exit are varied but most commonly the company is either floated in an IPO (Initial Public Offering), sold to another private equity investor or sold into a continuation vehicle. In private debt, the fund managers (there is often a cohort of lenders) will structure lending in such a way that the capital is returned at the end of a defined timeframe, having received the cash flows. The cash flows can then be used to refinance (re-up is a term often used) subsequent vintages.
Private Assets portfolio becomes self-financing after 5–7 years
Source: Schroders Capital.
Vintage years, consistent deployment and the impact on returns
A vintage year approach has the benefit of mitigating the risk associated with market timing. Despite our optimism for the mid- to long-term outlook for private assets, the near-term is undoubtedly going to be challenging for many investors, and keeping up a steady investment pace may be difficult. As the economic outlook becomes more cloudy and listed markets correct, private asset fundraising is likely to soften in 2023.
In addition to broader concerns over performance, some investors are facing the “denominator effect”. Private assets tend to correct less than other more liquid asset classes, so their relative weight in an investor’s portfolio tends to increase in a recession. This can limit the investors’ ability to make new investments into the asset class and maintain a determined percentage allocation.
Nevertheless, investors who can make new fund investments through periods of crisis or recession are well advised to do so. Our analysis shows that recession years tend to yield vintages that perform exceptionally well.
Structurally, funds can benefit from “time-diversification”, where capital is deployed over several years, rather than all in one go. This allows funds raised in recession years to pick up assets at depressed values as the recession plays out. The assets can then pursue an exit later on, in the recovery phase, when valuations are rising.
For example, the average internal rate of return (“IRR”) of private equity funds raised in a recession year has been over 14% a year, based on data since 1980. This is higher than for funds raised in the years in the run up to a recession – which, at the time, probably felt like much happier times. For private debt and real estate, there are similar effects. For infrastructure, the effects should also show a similar pattern however longer-term data is limited in this part of the asset class.
Private equity funds raised during recessions have performed well
Private equity vintage performance (average of median net IRRs)
Past performance is not a guide to future performance and may not be repeated.
Source: Preqin, Schroders Capital, 2022. There are 9,834 funds in the Preqin database. Only funds with vintage year after 1980 and to 2017 are analysed. 220 funds which were out of distribution were excluded, reducing the number of funds in our universe to 3,400. Private equity only investments, venture debt and funds of fund strategies have been excluded.
Pacing illustration for an investor
Our advice for allocating to private assets will, of course, vary by client and will always be led by the overall suitability of an allocation. Important factors such as a client’s overall income and expenditure, time horizon, investment understanding/experience and ability to tolerate illiquidity are all factors we consider when deciding on the exposure to private assets. For the sake of illustration though, let us assume all individual clients fall within one of four risk brackets: cautious, balanced, growth and aggressive. What would the investment pacing look like for the private asset allocation?
For a client on a growth risk mandate (this would mean a typical exposure to equities of between 50-80%) who has a good understanding of investments – a target allocation of 20% might be appropriate across private debt, private equity and real estate.
While we want to diversify by asset class, we also suggest spreading investments across a range of structures. This could include an early allocation to “evergreen” private equity, private debt and real estate funds: these funds do not have a pre-determined lifespan and can run in perpetuity, recycling investment proceeds and raising new capital as required. The investor could then additionally build exposure consistently over the five year period into annual vintages of a private equity fund of funds, and selective opportunistic private equity strategies which might cover more specialist parts of the market such as a secondaries or a venture fund.
An illustrative Private Assets Investment Journey
Source: Cazenove Capital. Note FoF denotes Fund of funds.
It’s so important that investors be educated and prepared for the allocation to be left untouched for an extended period. Private equity funds typically run for at least seven years, during which time the allocation will not be liquid. The realisation of the assets will also take several years, tapering down in the same way the allocation is gradually ramped up. This is why a complete understanding of a clients overall financial position is absolutely crucial when considering building a private assets allocation.
Private Assets - Investment risk: 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. 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. Any secondary market tends to be very limited. Investors may well not be able to realise their investment prior to the relevant exit dates.
Issued in the Channel Islands by Cazenove Capital which is part of the Schroders Group and is a trading name of Schroders (C.I.) Limited, licensed and regulated by the Guernsey Financial Services Commission for banking and investment business; and regulated by the Jersey Financial Services Commission. 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.