While publicly-traded equity and debt markets receive far more attention, private markets have rapidly grown in both size and importance in recent years. For example, McKinsey found that the net asset value of private equity funds has grown by 7.5x in the 2000s – twice as fast as public equity market capitalization growth.1 Similarly, the number of private equity-backed companies has grown from roughly 4,000 in 2006 to 8,000 in 2017. Meanwhile, the number of publicly-traded firms in the U.S. fell from roughly 5,100 to 4,300. At BBH, our Investment Research Group (IRG), which is responsible for asset allocation and manager selection for our Private Banking investment platform, believes that systematically allocating capital to top-tier private market investments can be additive to many of our client’s portfolios.
Why Invest in Private Markets?
At the most fundamental level, investing in private markets allows investors the chance to earn an illiquidity premium over marketable securities with comparable risk. IRG thinks critically about the opportunity cost of deploying our clients’ capital in any investment. If we are investing outside the public markets, where clients would have daily liquidity, we always consider whether we are being compensated adequately for locking up their capital. Fortunately, the private markets provide several opportunities to earn incremental returns that are not available to public market investors. Some of the areas we find attractive include private equity, direct lending, real estate and distressed debt. While we invest in each of these strategies, we will focus on private equity for the purpose of this section, as it is BBH’s largest private markets allocation.
Access to a larger universe of high-quality opportunities
Private markets are home to a rich and diverse set of investment opportunities that do not trade in the public markets. For example, while private businesses are typically smaller compared to their public peers, they can exhibit the same high-quality characteristics that market participants traditionally associate with large public companies. Private companies can offer mission-critical products or services, are often market share leaders in their industries and can exhibit attractive unit economics paired with the potential of high returns on invested capital and long runways for growth. The combination of these attributes can allow investors the opportunity to find unique private company investments.
Overall, we believe the private equity markets investable universe offers businesses of comparable quality to our public market investments. It also benefits from differentiated opportunities for value creation including sourcing, structuring and operational expertise, which are described in more detail as follows.
Adding value from sourcing and structuring
Private equity investors must independently source and structure their investments, which creates challenges as well as opportunities. In private equity, for example, sourcing expertise can add value if an investor is able to engage a company’s management team on a potential acquisition before other buyers are even aware the business is for sale. In other words, the opaque nature of the private markets makes these undiscovered opportunities and corresponding off-the-run transactions possible. There is no comprehensive list of all private businesses, much less a list of all private businesses up for sale. Therefore, in these instances, buyers will face less competition for the assets, an advantage that often leads to a better price. Yet another aspect of private market value creation and risk management is the ability to negotiate the terms of the investment, which includes the potential to better align the management team’s incentives with the fund’s interests. In the public markets, investors must accept the terms of the security as written, and changing management incentives often requires a successful activist campaign or proxy fight.
Ability to earn returns from operational expertise
Private equity buyers with unique industry relationships and expertise can add value for investors both on the initial identification of deals and by creating value in the company post-close. An experienced private equity team with a deep skill in a specific industry can often prove to be a more capable partner relative to a purely financial buyer trying to earn returns from financial engineering.2 In such instances, management teams may be willing to award the deal to the partner that can provide the best resources or dilute their equity ownership more than they otherwise would, all while holding the belief that the private equity partner’s operating expertise will drive outsized growth and operating efficiency over time.
One such common resource is operational expertise. Private equity teams of all sizes are building out internal teams comprised of former management consultants who have the time and expertise to improve a business’s pricing strategy, increase factory productivity or source talented executives. In fact, in 2017, Yale University CIO David Swensen referred to private equity as a “superior form of capitalism,” in large part due to the ability of talented teams to make a company better during their hold period.3
Flexibility in capital deployment
By virtue of the closed-end structures that are used in private equity funds, the general partner (GP) has the flexibility to call capital from limited partners (LPs) when compelling opportunities present themselves, and conversely, to shrink their capital base by being net-sellers of assets when market valuations are rich.4 In order to fully benefit from this dynamic, LPs must have a plan to efficiently fund future capital calls, and they must also be prepared to reinvest distributions in a timely manner into other suitable investments. Savvy public markets investors can accomplish something similar; however, the contractual capital commitments that LPs make to private funds often enable these investors to more quickly take advantage of attractive opportunities. The option value of committed (but uncalled) capital can be another important driver of return, though it is often realized in an irregular fashion as market cycles present attractive dislocations between the price and value of assets.
How does one invest into a private market fund?
In contrast to public market funds that typically have liquid and open-ended structures, investing into private market funds is a long-term endeavor that requires disciplined and active management. Private fund lives are typically 10 years at a minimum and are broken into three different periods: (1) investment, (2) harvest and (3) divestment, each of which we describe below:
The investment period is typically the first three to five years of the fund’s life, during which the GP sources, diligences and acquires their portfolio companies. The fund calls the LPs’ capital as each company is added to the portfolio. Depending on the strategy, additional capital may be required to acquire a complementary business or to complete other strategic operational initiatives.
The time from investment to exit (or divestment) is the harvest period. During this period, the GP is focused on optimizing and growing the businesses. Typically, the portfolio companies’ management teams and the GP work hand in hand to execute their value creation plans. During this time, portfolio companies may require incremental capital or distribute profits and income. Eventually, investor cash flows transition from negative to positive as the portfolio companies require less investment and begin distributing cash back to investors.
The conclusion of the harvest period is marked by the sale of portfolio companies, known as the divestment period. The sale proceeds, inclusive of invested capital and market appreciation, are returned to the fund.
How does one understand the cash flow dynamics of private funds?
Private market fund's cash flow often follows a unique pattern, referred to as the J-curve. As seen in the nearby chart, a fund investor’s net cash position (blue line) is the sum of the fund’s cash outlays (blue columns) plus cash inflows or distributions (orange columns). The investor’s net cash position with respect to the fund is subject to a “J-curve effect” where capital is called early in the fund’s life, after which it takes several years for investors to receive enough distributions to reach a breakeven cash position, and eventually realize a positive return. The final net cash flow to investors will not be known until the fund’s final position is exited and the proceeds are distributed to investors.5
Interestingly, as seen in the aforementioned chart, an investor’s capital at risk rarely reaches the level of his total fund commitment due to the early distributions in a fund’s life. In other words, the fund will return capital from dividends, asset sales or recapitalizations from existing portfolio companies while continuing to make new investments. Notably, these distributions do not require an outright sale of the investment – in a dividend recapitalization, for example, an investor can reduce the amount of his equity at risk but still compound capital through continued ownership of the business or property. In some successful transactions, the fund can even return its entire cost basis in the investment to LPs while maintaining ownership, which is akin to “playing with house money.” Due to the regular return of capital, clients in most instances will not have more than 75% of their fund’s commitments invested, despite having 90% or more of their commitments called. The practical takeaway is that the investor must commit more capital to private markets than she intends to have invested at any time.
How does one construct a private markets portfolio?
A single private fund investment does not make a mature private markets portfolio. Unlike public market funds that reinvest capital following the sale of a stock, private funds return capital to investors when they sell an investment, which means these investors must commit to new funds to maintain the same level of exposure.
At BBH, IRG aims to diversify our client’s private markets portfolio across different vintage years (year of the fund’s initial investment) and strategies such as private equity, distressed debt, real estate and direct lending. However, we are always trying to expand our circle of competence and find new opportunities to deploy capital. Like all investing, private market returns will differ depending on the periods in which they are made. For example, many private equity funds that deployed large amounts of capital in 2006 through 2008 struggled to meet their return targets, as they were investing into highly-priced assets ahead of the financial crisis. In contrast, 2009 vintage private equity funds on average posted extremely attractive returns. Similarly, the performance of different strategies can vary depending on the market environment. Distressed debt, for example, is more countercyclical and allows investors to deploy capital into different assets and market environments than private equity, which is more procyclical.
While it is difficult to predict the period that will result in the most optimal environment for deploying capital, it is IRG’s view that to be a successful private market investor, it’s critically important to remain a consistent and methodical allocator to private markets across both vintage years and asset types. It is also important to invest with funds managed by GPs who respect valuation and a strong alignment of interest with the LP.
How much should one invest in the private markets?
In short, an allocation to private markets should be large enough to make a difference to the overall portfolio’s return (at least 5-10%), but not so large that the illiquid portion of the portfolio and unfunded capital commitment create unintended liquidity concerns.
As a private markets portfolio matures, it is often possible to fund capital calls for newer funds with distributions from maturing funds. While these cash in-flows and out-flows will never match exactly, a mature portfolio should exhibit these self-funding characteristics in most normal investment environments. In extreme circumstances, such as a deep economic recession, however, divestments slow and capital calls may increase, creating steep funding requirements as portfolio values decline.
As such, BBH advises clients to be mindful of the liquidity dynamics at play as private markets allocations rise. As illiquidity is a risk that rises in importance during a bear market, IRG conducted an exercise to help illustrate the impact of a large private market allocation during a bear market scenario.
Since marketable equities typically experience steeper mark-to-market declines during bear markets, a portfolio initially allocated 65%/20%/15% to public equity, private markets and fixed income, respectively, would emerge from a steep downturn (as shown in the above chart) at roughly 51%/25%/25%. In the same portfolio, unfunded commitments, a fixed dollar amount that initially represented 9% of the portfolio, would increase to 15% of the client’s assets. Total private markets exposure and unfunded commitments could increase from a normal portfolio weight of 27% to 29% to as high as a 40% weight in a drastic scenario like this one.
Consider what happened to several endowments during the 2008 global financial crisis. As many of these institutions overallocated to private investments, their private markets exposure and unfunded commitments increased to uncomfortably high levels. As a result, many institutions put pressure on private fund managers to reduce or release commitments due to concern about the lack of liquidity in their portfolios. Moreover, institutions were forced to borrow to fund potential commitments. Today top institutions track unfunded commitments closely and have robust plans for funding these calls when they come due.
Going into a downturn with an over allocation to private markets virtually eliminates the investor’s ability to opportunistically allocate to once-in-a-cycle opportunities in the public or private markets that emerge at the end of a downturn. Many sophisticated investors stood on the sidelines in 2009 as others with more liquid portfolios took advantage of extraordinary investment opportunities. IRG prefers that clients’ portfolios have adequate liquidity to increase equity risk in either public or private investments when the right opportunity is presented.
While aggressive private markets allocations may be more palatable to some growth-oriented investors, the risk of being overallocated to the private markets underscores our conservative approach to portfolio construction. With that said, BBH works hand-in-hand with our clients to better understand their liquidity preferences, spending needs and time horizons to determine appropriate long-term private markets allocations for each client.
At BBH, we believe that systematically allocating to private markets can benefit client portfolios. When done correctly, private markets investing exposes client portfolios to a rich universe of high-quality investments that are not available in the public markets. Private equity allocations must be managed carefully, however, and clients must ensure they are diversified across both vintage years and strategies, while paying particular attention to the amounts they commit. IRG focuses on all of these dynamics before recommending a new private fund for suitable clients, and BBH relationship managers are always available to help clients through the process of building exposure to these illiquid assets over time.
Private market funds are only available to qualified investors. Generally, they would include persons who are “Qualified Purchasers” for the purpose of the Investment Company Act of 1940 and “Accredited Investors” for the purpose of the Securities Act of 1933 and non-U.S. Professional Investors. Additionally, an investor in a private market funds should be aware that they will be required to bear the financial risk of this investment for a significant period of time.
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1 McKinsey. Private Markets Come of Age. McKinsey Global Private Markets Review 2019.
2 Generally financial engineering in private equity means levering the company with excessive amounts of debt.
3 Council on Foreign Relations. A Talk with David Swensen. November 14, 2017.
4 The general partner is a part owner and manager of the investment partnership and has discretion to make investment decisions on behalf of the limited partners. Limited partners are investors or “silent” partners in an investment partnership.
5 When an investor breaks even the realization multiple of distributions / invested capital equals 1.00x.