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The appeal of private markets at a time of great economic uncertainty

April 08, 2020 | Asset Management

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The appeal of private markets at a time of great economic uncertainty

The scale and ferocity of the COVID-19 pandemic have had a profound impact around the world - socially, politically and economically. With billions of dollars wiped off the stock market in a matter of weeks, the outbreak has restarted many conversations around the pros and cons of public versus private equities. 

While the bull markets of the last few years have had investors enjoying high annual returns, COVID-19 has reminded us all of the importance of a diversified portfolio and the role that private equity investments have to play. In the last month alone, the S&P 500 and FTSE 100 are down more than 15% and 17% respectively. Panic-selling and herd mentality have compounded to lead to a drastic market sell-off and a spike in volatility to the highest levels ever (even higher than the crash of 2008). 

Meanwhile, private equity investors are watching their investment valuations remain relatively steady by comparison as a result of the illiquidity of their investments. 

Why do private markets offer greater solidity?

In the current climate of uncertainty, investors tend to look to tangible holdings; and cash is often king. $1000 today will still be the same $1000 tomorrow, whereas your stock holding value could potentially continue to sink to (technically) as low as $0. 

As investors sell off their investments to cash, an excess supply of stock leads to crashing market prices. The liquidity that investors tend to prefer when allocating to public markets has now become their biggest downfall. 

Of course, private equity transactions are not entirely immune to the same economic drivers, and their value can also potentially plummet. However, the fundamental difference is that they have longer-term horizons and cannot merely be “traded” like liquid securities. Private investments tend to be tied to more tangible outcomes of a company based on its proposition, the management team, client base, and so on. That means that when economic fear spreads and people return to cash, private investors sit with their cash tied into longer-term investments that can overcome market downturns. 

Investing for long-term returns

One of the critical factors that influences an investor’s approach is about their attitude to liquidity. Does the idea of locking their money away for 5-10 years sound appealing? Or would they rather invest in traditional capital markets knowing they can withdraw at any moment? The lack of liquidity in private equity tends to be what leads to higher returns as the investments earn a liquidity premium. 

Investors with shorter-term goals or those that prefer to have greater flexibility, tend to favour public markets; while institutional investors who can afford longer-term horizons such as endowments and pension funds tend to diversify their portfolios and include higher allocations to private equity. In market downturns, private investments will see valuations remain relatively constant, while public equities tend to be the first to drop.  

Limiting exposure in volatile markets

The investment textbooks will always state that diversification of a portfolio is key to minimising risk. In market downturns such as the current one, a portfolio split equally between public and private equities will see a smaller drop in value compared to one that is exclusively invested in public securities. Therefore, private securities can help to limit the impact of volatility generated from public equities. 

Seasoned investors tend to opt for a fund with smooth and consistent return profiles than one with wildly volatile swings driven by fear and market sentiment. Volatility in public equities is often overlooked and driven by a herd mentality, and less by actual market valuations of companies. Therefore, combining public and private equities offers a more sensible approach that can combine the best of both worlds.  

The changing face of private market liquidity

Private investments are not for everyone. A lack of liquidity means a lack of accessibility and being able to keep huge sums of cash tied up for long periods is a luxury only often afforded to the very affluent and institutions. However, this doesn’t mean that private investors don’t struggle for cash and need to liquidate their holdings quickly. Therefore, selling off private equity transactions have often been seen as “panic” decisions to shore up finances, which has resulted in the selling of these stakes at large discounts. 

 However, the lack of liquidity in private equity markets is slowly changing with the last few years seeing a significant change in the appetite for secondary private transactions. In a private equity investment, the first few years are always the riskiest. Secondary transactions enable investments to be made at a time when the highest level of risk has passed, future cash flow and valuation projections look more accurate and reliable, and the general time to maturity is shorter. As investors begin to realise the merit in secondary transactions, demand has picked up and has led to increased liquidity. 

Is now the time for private markets to become a mainstream option?

The last decade has undoubtedly seen a shift-change in attitude towards private markets. Once deemed as an option only for investors with a significant willingness to take on risk, reduced returns from public markets has resulted in a far greater appetite for private investments. As a result, financial institutions are now adapting their propositions to ensure that they can satisfy the growing demand from their high net worth clients.  

While the economic outlook is undoubtedly uncertain at the moment, private markets do seem to have established themselves as a fundamental part of sophisticated investment portfolios for the foreseeable future.

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