Both private equity and private debt can provide valuable diversification and risk-adjusted returns.
Over the past two decades, the number of companies listed on public stock and bond markets has steadily declined worldwide. Does this mean fewer businesses require financing for growth? Far from it.
Today, more companies are turning to private markets for capital and other funding. Private markets often offer longer investment horizons and terms that are tailored to the specific needs of individual companies.
For investors, these characteristics present compelling opportunities. Exposure to private markets can not only enhance returns but can also strengthen portfolio diversification - key attributes that, in our view, should be integral to every long-term investment strategy. However, investing in private markets can present a range of risks that mean that these instruments may be most appropriate for professional investors.
The term "private markets" covers various asset classes, with private equity and venture capital (VC) being the most recognisable. In private equity and VC, investors acquire ownership stakes in privately held companies. Other private market asset classes include private debt and private infrastructure, which have outperformed more growth-driven investments such as private equity and VC since interest rates started rising in 2022.
The fact that not all private market asset classes perform alike underscores the value of diversification. It can be important to be strategic in allocating to a variety of private market asset classes. Such an approach can help a well-rounded portfolio to weather various market cycles. Of course, there are no guarantees that diversification can protect entirely against investment risks.
Investing in private companies is inherently more intricate than purchasing public stocks. The process is less standardised, typically involving months of negotiation to arrive at mutually agreeable terms. Consequently, for most private clients, the most effective route to gaining exposure to private markets is through professionally managed funds. These funds are led by experienced teams that leverage their proprietary networks to identify attractive investment opportunities.
Private equity investments typically rely on managers buying companies at attractive prices, driving operational improvements and selling them at a higher valuation within four to seven years. However, market uncertainty in recent years has made it difficult for buyers and sellers to agree on pricing, resulting in fewer transactions. Looking forward, we anticipate a resurgence in private equity activity as interest rates ease and some of the broader global challenges such as inflation abate.
When private investments reach the desired return, there are several avenues for liquidity. These include selling the company to a larger competitor, a financial investor looking for further growth potential or transitioning to public markets through an initial public offering (IPO).
Although IPO activity has been relatively subdued in recent years, we expect a return to more typical levels should interest rates continue to decline. Mergers and acquisitions activity is sensitive to recent political shifts, particularly in the US. Additionally, exits to other financial investors - known as "sponsor-to-sponsor" transactions - are anticipated to exceed pre-pandemic levels in the coming months.
As traditional routes to liquidity have become less accessible, many investors are turning to the growing secondary market. This segment, which involves purchasing existing private investments at discounted prices closer to maturity, has more than tripled in size over the past decade. Secondary market growth offers investors more avenues to realise gains in private equity investments.
Private equity continues to be the largest asset class in private markets, but the landscape has shifted significantly. In today's higher interest-rate environment, profitability has emerged as the dominant focus, with "growth at all costs" no longer a viable strategy. This means that successful private equity investments will increasingly depend on a manager's ability to drive operational efficiencies, rather than simply capitalising on cheap debt.
Given this evolution, not all private equity managers are equally equipped to navigate these changing dynamics. As a result, selecting the right manager has never been more important to achieving sustained success in this investment area.
Private debt and private infrastructure are rapidly growing asset classes that offer significant potential for investors. Private debt - loans extended to private companies and not available for purchase on public markets - has delivered attractive returns, particularly in the context of current high interest rates..
Direct corporate lending, which provides crucial financing to middle-market companies that lack access to traditional bank funding, continues to grow. Private equity deals often involve a combination of private equity and debt financing, and with the significant amount of equity capital raised in recent years, there will be continued demand for debt financing, much of it in the private markets.
Further diversification within private debt can be found in asset-backed lending (where loans are secured by physical assets such as real estate or machinery) and mezzanine financing (which offers flexible capital solutions when traditional financing options are unavailable). These forms of debt can not only provide diversification but can also help to diversify risks.
All private investments bring an increased liquidity risk. Unlike public market instruments, private market securities cannot always be sold or sold at a profit. Because of this characteristic, as well as the sometimes-complicated terms negotiated within private deals, they may only be appropriate investments for professional investors.
An allocation to private markets, whether through private equity or private debt, should be a cornerstone of any well-rounded investment portfolio. Much like public equities and bonds, private markets offer a range of opportunities across the risk spectrum, with the potential for returns and portfolio diversification.
