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Private markets – new investment prospects for individual investors

Rising interest rates, rampant inflation, geopolitical instability and merely mediocre return outlooks on equity markets – it sure feels as though investors have known simpler times than the present. Private-market assets help to overcome these current challenges. They enlarge the investment universe, protect against inflation, motivate adherence to a disciplined investment strategy and improve a portfolio’s risk-return profile. Kaiser Partner Privatbank is now making the benefits of private markets accessible also to individual investors.

 

Private (more and more preferably) for longer and longer

What do ByteDance, SpaceX, Klarna and Revolut have in common? Investors value all of those companies in the billions of dollars even though they are not listed (yet) on a stock exchange. They all are also referred to as “unicorns” even though there are hundreds of such companies by now and they thus no longer are truly a rarity because compared to before, growth companies are staying privately held longer and longer these days. Whereas Amazon was just three years old when it went public in 1997, Facebook waited eight years before launching its IPO (2012). Uber (2019) and Airbnb (2020), in contrast, were teenagers when they debuted on the stock market. Individual investors thus were unable to participate in their business stories until very late in the game while the bulk of the companies’ equity value appreciation went to those investors that had been able to invest in them at an early stage on the private market (via venture capital funds).

 

Enlarged investment universe (1)

Companies are staying privately held for longer and longer

Age of company at time of IPO

Sources: HarbourVest, Kaiser Partner Privatbank

 

Investors who (have to) concentrate solely on publicly traded companies miss out on interesting investment opportunities that are frequently more profitable than average, not just in the realm of startups and growth companies, but also in the sphere of established enterprises. A single statistic illustrates just how big the opportunities are and just how large the private markets investment universe is: almost 90% of all businesses in the USA with annual revenue above USD 100 million are privately held companies not listed on a stock exchange. Europe presents a similar picture. Fewer regulations and disclosure requirements and less pressure from shareholders to reach short-term targets contribute to motivating companies to stay privately held for longer and longer or to even delist from the stock market. An increasing number of companies are owned by private equity firms.

 

Enlarged investment universe (2)

Opportunities in private markets are constantly expanding

Number of companies in North America and Europe (privately held vs. publicly traded)

Sources: Pitchbook, World Federation of Exchanges, Kaiser Partner Privatbank

 

Premiums to be earned

On paper, private equity is a relatively simple concept. Private equity managers raise capital (commitments) from (wholesale) investors and invest the funds in a number of different companies for a period of three to five years. In each of those deals, the managers seek to create added value by means of growth strategies and operational improvements and by tweaking other adjustment screws (valuation expansion, capital structure optimization) and to afterwards resell the company, usually after a term of three to six years. Handsome fees (frequently a 2% annual management fee plus a 20% performance fee on returns above a defined hurdle rate) generally make this model a lucrative business for private equity firms. But private equity managers do more than just rake in fees – they also put up a significant part of the investment capital and thus take on risk themselves. Their interest in a value-enhancing investment is thus aligned with investors’ desire for a good return. Hence, private equity has indeed paid off for investors as well in the past. Depending on the precise definition and the specific time frame, during the last two decades this asset class has generated an excess return of 3 to 5 percentage points versus the world equity market over lengthy periods and, seemingly at least, with less volatility.

 

Illiquidity premium (1)

Private equity has the edge in the long run

Growth of one US dollar

Sources: Hamilton Lane, Kaiser Partner Privatbank

 

That extra return stems from the use of the instruments in the private equity toolbox described above, but also from information asymmetries, from a certain degree of complexity and, above all, from an illiquidity premium. That’s because the bulk of the committed investor capital in private-market investments is typically locked in for many years. Selling during this period normally can only be done at a (usually substantial) discount to nominal value. The private equity asset class thus appears to many an investor to potentially entail higher risk. On the other hand, though, the illiquid, long-term nature of private-market assets helps investors to avoid panic selling during periods of stress and to refrain from wanting to time the market. This inherent disciplining attribute of private markets increases the chances of realizing the targeted extra return.

 

Illiquidity premium (2)

Private equity outperforms in times of weak stock markets

Excess return on private equity (annualized over three years)

Sources: Hamilton Lane, Kaiser Partner Privatbank

 

This excess return seems particularly valuable especially in today’s challenging investment climate. That’s because bonds currently bring neither a (real) yield nor stability to a portfolio. And although stocks are no longer completely overpriced in the wake of the recent correction, their expected returns for the next five and ten years are only in the mid-single-digit range. Private markets historically have delivered a handsome excess return precisely during such uninspiring times on public markets. The private markets asset class is also at a relative advantage in light of the elevated inflation rates today (and potentially also in the future) because returns on real assets and private equity have a much higher correlation to the rate of inflation than bonds and stocks do. Private-market assets have thus meant effective protection in past periods of rampant inflation.

 

Protection against inflation

Elevated inflation brings tailwinds

Average returns at different inflation rates (1999–2019)

Sources: Bloomberg, Hamilton Lane, Kaiser Partner Privatbank

 

Challenge and (your) chance

Investors who wish to profit from the many benefits of private markets are confronted with various challenges, however. Carefully selecting the right investment funds, for instance, is a crucial key to success particularly in the private equity sector because there is a huge performance differential there between “good” and “bad” managers (in contrast to public equity markets). Only those investors who consistently select funds that generate above-average returns (ideally ranking in the first or second performance quartile) number among the winners in the long run. Accomplishing that requires not only the ability to gain access to the best managers, but also considerable capacity to perform due diligence. Moreover, a private markets portfolio geared to the long term should be diversified across different dimensions (strategies, sectors, geography, investment duration). Capital commitments must be made for multi-year terms, and capital calls and commitments by and to different private equity funds must constantly be managed. All of that requires professional expertise and entails a lot of administrative work. But arguably the biggest investment obstacle to date – even for wealthy private clients – has been the very high minimum investment volume needed to participate in the performance potential of private equity and the like because top-tier managers normally charge an admission of USD 10 million or more when they take new investors on board.

 

The good ones go into the pot, the bad ones go into your crop

Wide performance dispersion between private equity managers

Performance quartiles of buyout funds by investment year

Sources: Hamilton Lane, Kaiser Partner Privatbank

 

The possibilities created by digitalization enable the barriers to investment described above to be lowered nowadays. It’s not for nothing that there’s lots of talk about the “democratization” of private markets these days. Kaiser Partner Privatbank has developed an innovative offering that enables clients to gain diversified exposure to private markets with a low minimum investment amount. This offering gives our clients more than just access to the best managers. In addition to taking over all of the administrative tasks as a matter of course, our private markets mandate comprises a customized solution that also includes financing or monetization of the investment. Last but not least, our offering also includes access to a secondary market. Our service therefore makes private markets not just accessible, but also (semi-)liquid for existing and new clients. More return for less risk – Kaiser Partner Privatbank opens this performance prospect to existing and new clients through its private markets mandate.

 

More return…

…for less risk

Return and risk for mixed portfolios (1995–2020)

Sources: Hamilton Lane, Kaiser Partner Privatbank

 

Oliver Hackel, CFA Senior Investment Strategist

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