First published in Family Capital
As public markets shrink investors have many reasons to focus on long-term returns in private markets, but many challenges await
It has happened so slowly you may not have noticed, but the public markets are in something of a crisis.
The number of listed companies in the US which today stands at around 4,000 has never been lower, and barely half the number of the late 1990’s. The same pattern holds in the UK with 2,000 listed companies being close to the smallest number for 40 years.
Today’s growth companies (Uber, Slack, Spotify or AirBnB) are going public much later in their journey, potentially when the juiciest investment returns have been squeezed out. Without the influx of new blood, the listed small cap sector, once an engine for growth, is withering on the vine.
The private credit markets are also playing a big role in controlling some of the UK’s leading retail brands (Debenhams, Travel Lodge) as well as transformation capital for some of our bravest business turnarounds (Café Rouge, Bella Italia ).The debt capital markets still exist. But they have changed substantially with banks and dealers playing a smaller role compared with pre-2008.
Not surprisingly moves are afoot to find ways to include private markets in the retirement accounts of individuals both in the U.K. and the US. With even Vanguard announcing the roll out of private equity to some clients. And with meagre income yields available on bonds, private markets are being touted as a potential allocation for individuals needing income.
It is only fair to add that public markets have had a fantastic run in terms of returns. But returns are being driven by an ever-narrower set of technology giants which now make up more than a quarter of passive, and ETF, portfolios in the US.
The rise of private markets
All this means private assets are increasingly in favor. But just because an asset is illiquid, unlisted or “long-term” in nature this is no guarantee of good returns.
According to Patient Capital – a book by Harvard academics Josh Lerner and Victoria Ivashina – the median private equity fund has failed to out-perform a public markets comparator since the late 1990’s.
In part, this is because private markets are rife with issues, particularly agency issues, which can erode returns. FEES being the main issue.
Ludovic Phalippou brought this home recently in stark fashion in a well-covered paper: The inconvenient truth, private equity returns and thr billionaire factory.
Managers, for example, tend to gather assets to maximize income from large fixed fees (traditionally 2% per annum) rather than focus on performance. Data cited by Lerner and Ivashina shows that mean internal rates of return (IRR) fall by 2% a year for each 60% growth of a fund compared to its predecessor.
A fund 200% larger than a previous one would on average have an annualized IRR 6% lower. But managers often charge similar fees, no matter how much they are running. Co-investment can mitigate this to some extent, but brings additional challenges of oversight.
The IRR as a return metric is not well-understood, even by investment professionals (read more here), and prone to manipulation which can make all funds seem top quartile. A key issue relates to the fact that modest returns earned over a short period of time can skew the metric considerably, and a large return earned and paid out quickly many years ago creates an artificial high “stickiness” to the calculation for decades afterward.
The terms of partnership structures commonly used in private equity have hardly changed in centuries. The 20% carried-interest fee model is traced back, variously, to the contracts between whalers and their crews in 19th century Massachusetts or the 14th century contracts of Genoese and Venetian trading firms. The life of a fund extending to 10 years is also more in line with tradition than investors’ interests.
There are surely better ways to bring alignments up to date for limited partners, who put up their money but cannot take back control.
So, what can be done?
In our view, investors should focus on areas where agency issues have been best addressed, and there are three sectors which stand out.
Private infrastructure funds which now charge fee levels at a fraction of those common a decade ago, offer evergreen terms which give investors more control, and align better with the long-term nature of the assets. Managers are increasingly focused on improving the environmental and social impacts of the projects and assets they manage as well as delivering strong stable growth returns.
Their investments in assets and operating companies cover a broad range of infrastructure sectors: renewable energy, ports, airports, toll roads, pipelines, around the world.
Private credit. These assets – typically loans or debt with a 3-7 year maturity – naturally align with the typical fund term. Lobbying has been successful in bringing fees way down from the traditional “2&20” space, to roughly half that.
They invest in direct loans to everyday small or medium-size firms, including some of today’s most innovative small firms. Another avenue, particularly popular in the current climate is funds that focus on stressed and distressed situations such as turnarounds.
Social & affordable housing. For asset owners focused on more stable income streams with a preference for direct UK inflation linkage there are offerings now that focus on buying and leasing back properties to public or semi-public bodies to house a variety of occupants such as assisted living and asylum seekers. A key characteristic here is that these will have very long tenancy agreements in place with minimal default risk. Many of these funds would have an impact investing mission and independently audit their impacts in line with the UN Sustainable Development Goals (SDGs).
The governance challenge
It is not enough though to spot good investments. Over the long term, the oversight and governance of private markets programs is key to avoid impulsive behaviour and ensure that good judgement and patience prevail. This was core to the philosophy of David Swensen, the pioneer of a private market investment approach at the Yale endowment in the 1980s.
Asset owners need to get involved to build the right team, retaining professionals capable of keeping a grip on the key oversight and control issues within private markets while thinking strategically. Framing discussions appropriately around the big picture is key to avoid the perennial temptation of getting dragged “into the weeds”. A grasp of detail is important, but an excessive focus on minutiae can obscure the biggest strategic risks and opportunities. This holds true across private markets – within debt, equity buy-outs or indeed venture capital.
Communication is more important than you might think to ensure asset owners are seen as good stewards to the public – and potential recruits. You also need a decent profile to be offered new deals.
Asset owners also need to measure and report on their private markets investments, as in any other asset class. The focus should always be on long-term returns.
The best investors that we work with have a limited set of diverse metrics that are regularly reviewed and remain the same through time so that the language and discussions around them become familiar and are allowed to develop over the years.
To avoid death by analysis, the focus should be on things that are directionally correct as these will be far more powerful decision-making tools over the long term rather than over-precise measures which may have errors of assumptions.
Private markets are in high demand as public markets have waned. But they are rife with issues and need to be approached with knowledge and experience. Getting governance and measurement right matter more than you might think.
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