Why Private Markets Outperform (And Why This Is Sustainable)
The market for private investments - which includes private equity, private debt, direct real estate, and infrastructure - has grown steadily since the Great Financial Crisis nearly two decades ago.
This is due to a number of factors.[1] While regulations on public exchanges have tightened, the private markets have deepened to provide more types of financing, and the industry itself has professionalized to meet the increase in demand. From an investor’s perspective, however, the most attractive features of private investments are 1) Diversification, 2) Lower volatility, and 3) Higher returns.
As the global economy continues on its somewhat stormy path this year, all three advantages should continue to be in strong demand. But investors will - and should - be skeptical regarding claims of high returns - especially when marketed as ‘persistent’.
Typically, “higher return” means higher risk. Or in other words, higher risk of underperformance when external conditions change for the worse. In this article, we dig a little deeper into the source of private markets’ past outperformance, and ask whether it is sustainable in the coming years.
The Illiquidity Premium
The received wisdom is that private markets offer higher returns because they are less liquid than public investments. It is true that private markets investors agree to commit their capital for multi-year periods. It’s also the case that private deals are - by their nature - harder to exit than public equivalents. Hence, an illiquidity premium makes sense to offset this higher risk.
But this is not the whole story. Few investors commit their entire wealth to private investments. This means that the illiquidity risk depends on the investor’s situation, and can be quite low. Furthermore, as private markets have continued to grow in sophistication, investments are becoming less illiquid over time.[2]
The long-term outperformance by private markets relative to public equivalents, despite higher demand and lower liquidity, suggests that there is more to the story.
The Complexity Premium
A series of articles published by Schroders in 2021 focuses on the idea of a ‘complexity premium’ in private assets.[3] It’s a more formal way of talking about ‘value creation’ that is often discussed in the context of private equity, but applied across private markets as a whole.
He defines the complexity premium as a result of two factors:
A complex situation
A set of (rare) skills able to enhance and improve it.
Let’s take an intuitive example. Suppose you buy a property as an investment. The property is in a good area, but the interior is outdated (1980s decor), the wiring is non-compliant, and the yard is overgrown.
Your returns over the holding period will be determined by income (i.e., rent) and the eventual sale price. How large your return is will be governed by some factors outside your control - such as supply and demand for housing, interest rates.
However, if you actively enhance the property (e.g. upgrade electrical and plumbing) or split it into two rental properties, you can significantly increase your returns. A complex task, and one that requires a certain level of experience and know-how - but well worth the time and effort.
In the same way, the complexity premium for a private asset is determined by the time, energy, and experience that goes into enhancing a deal or business over the course of the investment period.
The alternative is to hold an asset in the hope that external circumstances (economy, competition, regulation, interest rates) will favor a higher exit value.
This is effectively the position of an investor in the public markets. Without a substantial stake (at least 5-10%) it is impossible to exert any meaningful influence on the direction of the firm. Not only this, but certain mechanisms (such as dual-class share structures and onerous voting requirements) give management disproportionate influence over important decisions. In many cases, this means that they can overpower even large shareholders, further diluting the power of public ownership.
If this is the case, the complexity premium can go a long way to explaining the difference between public and private market returns.
The Stages of Value Creation
While straightforward to grasp conceptually, in the specific context of private markets investing, the ‘time, effort and experience’ behind the complexity premium can take many different forms - not only across deals but over the lifetime of a deal.
The four stages outlined below are based on the original Schroders article, referenced above.
Finding: Locating deals requires a network and the ability to unearth opportunities from it. By definition, this is restricted to a relatively small number of individuals.
Assessing: There are more bad deals than good deals, and the ability to tell one from the other requires experience, ideally sector-specific, as well as the necessary financial know-how to identify and mitigate risks in the structure of the deal itself.
Managing: Once an opportunity has been identified, executing on the plan is generally the hardest and longest part of the process. It requires, amongst other things, the ability to hire, fire, and pivot in response to deviations from the expected trajectory.
Selling: Here, once again, network and reputation are often key, as numerous potential buyers must be found, and persuaded of the asset’s worth, in order to realize the value of the hard work that has come before.
The “complexity” of the above process serves to illustrate the initial point. Because the required mix of hard and soft skills is hard to come by, it is natural that a premium should exist to compensate for them.
Conclusion
When done correctly, private investments have the potential to deliver high returns and low volatility, without needing to take on higher risk.
However, as seen above, the skills must be there in order to make good on the opportunity. Simply investing in non-public deals is not sufficient to achieve success. The complexity premium depends on the team who executes.
At Petiole, we can advise our clients with confidence, thanks to over 20 years of experience, a global footprint, and a dedicated team managing USD 2.2 billion in assets, specializing in co-investments across private equity and private credit. We offer deep expertise in a market where depth and expertise make all the difference.
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