There has been a clear shift from public markets to private markets. Private markets are no longer an opportunistic satellite, but are now the core of the investment portfolio.
From the end of World War II until the 1970s, companies have gone public to raise money to finance their growth. In recent decades companies have become less capital-intensive. Factories are now in Asia and just about everything comes as-a-service from the cloud, making even the most expensive IT systems hopelessly obsolete. There has also been a sharp improvement in access to private markets that have matured in recent years. The only reason companies still go public is because existing shareholders want to sell.
There are now more companies owned by investors in private markets than there are listed companies. However, private companies are often at the beginning of their growth phase, something we hardly see anymore on the stock market. This probably also means that on the stock market, past returns are no longer indicative of the future. After all, most shareholder returns are made during that rapid initial growth phase. That suggests that private equity returns are underestimated, as companies remain in private hands for longer and longer during that lucrative growth phase.
PE returns higher in the future
Another reason why private equity returns will be higher in the future than in the past is the great need for companies to change. With the IT revolution, developments are moving exponentially faster, while existing listed companies are increasingly struggling to adapt. Listed companies are often caught in stifling regulations and hire expensive consultants for change processes, only to see the implementation of such a change fail thanks to protesting stakeholders. This while private equity is ideally suited to digitally transform companies or make them suitable for the energy transition. One major shareholder who is simultaneously the unpaid consultant and who also takes care of the implementation works much faster. That added value cannot be found on the stock market, but it can be found in private markets.
There is also a private alternative for bonds, called private debt. What is particularly striking is the much higher returns on private markets while the risk is comparable. This is primarily due to the manipulation of interest rates in public markets by central banks in recent years. By lowering interest rates to zero, many bond investors were forced to look for yield. That search for yield resulted in lower and lower returns. The recent banking crisis shows that risk is still the flip side of that compressed return.
Private debt costs less
What’s more, especially with bonds, the costs of supervision are significantly lower. Because of high costs, a bank loan is much more expensive than what it really should be. Also, it is no longer obvious that this type of credit risk is on the bank’s balance sheet, while long-term investors are looking for returns. Part of the expensive supervision is further that lending is only possible when all the checkmarks are set. That too says nothing about risk, while it is precisely the return on the part banks have to leave high.
And finally, last year showed that government bonds are by no means risk-free. Losses on them are the cause of the recent banking crisis. Bond indices still consist largely of low-yielding but risky government bonds. After all, the mountain of debt is larger than ever and that debt is mostly held by governments. It is strange that this risky, barely-yielding paper should be the core of an investment portfolio. With the better-yielding private debt, the risks are often hedged by good collateral.
Real estate risks magnified
The third category of private markets is real estate. It is now fair to say that the experiment of investing in listed real estate has failed. Many Dutch real estate funds are back at price levels not seen since the 1990s. Even Rodamco, the Dutch real estate favourite of the 1980s, is almost back to square one in price terms. There are now German listed real estate funds with discounts of 70 per cent. This sounds attractive, of course, but for the incumbent investors it is no treat. People are still trying to lure investors into open-end real estate funds and still, for whatever reason, those funds then close anyway, followed by the irrevocable fall in share prices.
Real estate risks are greatly magnified on the stock market. Then private markets are better off. A key advantage of private markets is that an investment in private markets often has a head and a tail. For investors who have been entrepreneurs in the past, the risks are then much more manageable. Less risk and still more return in the end. It seems like an anomaly, but it is not. Private markets are now part of the core of the portfolio.
Han Dieperink is chief investment strategist at Auréus Vermogensbeheer. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. This contribution originally appeared in Dutch on InvestmentOfficer.nl.