Private markets – the right way

Investments in private-market assets have long ceased to be the exclusive preserve of institutional investors these days. More and more private-market investment offerings are explicitly being aimed at retail investors, but not all of the products on the market are retail investor-friendly. Kaiser Partner Privatbank offers a comprehensive solution that combines diversification and an attractive risk/return profile with comparatively high liquidity.

On the way to becoming mainstream…

Investments in private-market assets – i.e. investments in non-publicly traded enterprises and startup companies (private equity and venture capital), private credit, and real assets (infrastructure and real estate) – have long ceased to be the exclusive preserve of institutional investors (pension funds, foundations, family offices, insurance companies) these days. In fact, retail investors’ access to private-market investment products has improved considerably in recent years as a result of the drive to democratize private markets. Digitalization and innovative fintech companies are to thank for this trend, but it was also caused by a shift in thinking by private-market managers like Blackstone and StepStone, which, after the institutional client business had reached the limits of its growth by now, identified the retail client channel as a new source of capital with market potential in the multi-billions. At the same time, though, more and more retail investors are also recognizing the opportunities that private markets offer. Even though the era of ultralow interest rates is over and conventional fixed-income assets like government and corporate bonds have become a decent investment alternative again in the meantime, several points nonetheless argue in favor of blending private-market assets into an investment portfolio even under the new interest-rate regime:

• Enlarged investment universe: Access to private markets expands an investor’s investment universe many times over, particularly in the private equity space. Almost 90% of all companies in the USA with annual revenue above USD 100 million are not listed on a stock exchange, and only one in 20 companies in Europe with revenue of that size has an exchange listing. Meanwhile, young growth companies are staying in private hands for longer and longer, which means that the bulk of their value appreciation remains reserved to accrue to those investors who (are able to) invest in venture capital. The private credit sector is also steadily expanding because banks are increasingly pulling out of the business of extending credit financing to medium- and larger-sized companies. In the real estate sector, there are many exchange-listed alternatives to choose from, but their prices are generally very volatile and far removed from their intrinsic net asset value. The selection of vehicles for investing in infrastructure, on the other hand, is comparatively limited in public marketplaces.

A lopsided ratio | More companies (and opportunities) outside stock exchanges

Companies with more than USD 100 million of annual revenue

Sources: Hamilton Lane, Kaiser Partner Privatbank

Companies are staying private ever longer | Venture capital pockets the returns

Age of company at time of IPO

Sources: Bloomberg, Kaiser Partner Privatbank

• Protection against inflation: Even if inflation rates are on the retreat by now, preserving purchasing power remains a prime investment motive for many investors. Infrastructure and real estate assets particularly stand out among private-market assets in this context. They provide inherent protection against inflation because their earnings streams are normally linked to inflation indices. Meanwhile, investments in private-credit loans whose variable interest rates are tied to central-bank policy rates provide indirect protection against inflation.

Real assets outperform in times of high inflation… | …and provide protection against inflation

Average quarterly returns under different inflation regimes (Q1 2008 – Q3 2022)

Sources: Hamilton Lane, Kaiser Partner Privatbank

• Performance: Private-market assets have consistently generated higher returns than their exchange-listed counterparts over lengthy periods in the past. The outperformance by classic private equity buyout funds, for example, has amounted to around 300 to 500 basis points per annum and is attributable in particular to an illiquidity and complexity premium. The further growth of this asset class and the challenging and competitive environment in which it operates could cause this excess return to diminish in the future, but it is nonetheless likely to continue delivering a certain return pickup versus public markets.

Constant outperformance | Private-market assets regularly generate more value

Historical risk/return tradeoffs (15 years) Public vs. Private Markets

Sources: Hamilton Lane, Kaiser Partner Privatbank

• Enhanced risk/return profile: The performance of private-market assets is not just superior to that of stocks and bonds that trade daily, but is also steadier and less volatile due to specific valuation methods and longer valuation intervals. Although one can reasonably assume that the “true” value of private equity or private credit fluctuates at least just as much as asset values on public securities exchanges do and that a corresponding (de-smoothed) performance is estimable, this theoretical higher volatility does not show up in one’s investment portfolio. Blending private-market assets into a mixed portfolio composed of stocks and bonds thus substantially reduces portfolio volatility while at the same time boosting the return.

Greater return… | …with less risk

Historical risk/return tradeoffs for mixed portfolios

Sources: KKR, Kaiser Partner Privatbank

• Greater investment discipline: The real drawback of private-market assets – their illiquidity – actually tends to be more of an advantage from a behavioral science perspective. Since they cannot be offloaded on securities exchanges at the press of a button, this precludes panic selling during periods of market stress. The combination of illiquidity and attenuated volatility makes private-market assets an anchor of stability in a portfolio that helps to avert investor errors that typically arise during market crises – mistakes such as elevated risk aversion, suddenly wanting liquidity, shortening one’s investment horizon, and extrapolating recent trends into the future.

The journey matters | Private-market assets provide stability and enhance investment discipline

Wealth level and investor behavior

Sources: Pictet, Kaiser Partner Privatbank

…but not without potential pitfalls

The numerous benefits of private-market assets are readily evident, but whoever wishes to profit from them must also be aware of private-market assets’ idiosyncrasies (or hidden hazards…?), which include, for example, J-curve and blind pool risk. The J-curve describes the tendency for (net) returns on private-market investments (most notably in private equity and venture capital) to usually be low or negative in the first years because management fees have to be paid on the entire committed capital upfront while only part of this capital is actually invested right at the beginning. Blind pool risk, meanwhile, means that at the outset of his or her investment, an investor doesn’t know yet in which companies or transactions the private-market manager will ultimately invest the money. Another idiosyncrasy is the high variance of investment returns. Compared to public equity and bond markets, where there is a performance differential of 100 to 250 basis points between the best and worst 25% of managers, the dispersion of returns between top- and worst-performing private-market managers is much wider and even exceeds 15 percentage points in some cases. It therefore is imperative to perform thorough due diligence before selecting which private-market managers to invest in, and that requires professional expertise. In the end, however, perhaps the biggest drawback of an investment in a conventional private-market fund from the perspective of a retail investor is the liquidity of the investment or, better said, its illiquidity. In the case of a typical private equity fund, for example, 12 to 14 years elapse between the time of the capital commitment and the time of the full capital repayment. Whoever wants to get the capital back sooner can often sell his or her shares these day on the secondary market, but usually only at a sizable price discount.

The good ones go into the pot | Astute selection is essential in private markets

(Median) internal rates of return for private-market funds with vintages from 2009 to 2019

Sources: McKinsey, Burgiss, Kaiser Partner Privatbank

Apples and oranges

Common performance metrics in private markets can also prove to be tricky. The internal rate of return (IRR) metric in particular is a prominent target of criticism. Private equity managers frequently report astoundingly high IRRs of 15% to 30% for their funds. However, this metric always refers to the individual payment streams from a fund’s investments and various transactions and not to the total investment amount committed to by the investor. This means that an IRR of 20% that refers to just one-fifth of the committed capital equates to a much less spectacular 4% return on the total investment. Another problem with the IRR is the implicit assumption that a fund’s money that gets freed up over time can consistently be reinvested with the same high return. Moreover, the numerous adjustment screws that influence a fund’s IRR allow the manager to easily tweak the fund’s performance. The IRR cannot be simply compared with the time-weighted rate of return applied to conventional investments. One alternative metric is the multiple of invested capital (MOIC). It measures by what factor the initial investment amount has increased and at the same time exposes the shortcomings of the IRR. In order to reach an MOIC of 2, or to double one’s capital, over a period of 10 years in the case of a conventional investment in which all of the capital is invested upfront, a 7% rate of return is necessary. In contrast, an investment in a typical private equity fund that makes capital calls gradually requires an IRR of around 15% to arrive at the same terminal value (assuming that any uninvested capital is parked in the money market earning interest and is not invested in higher-yielding assets).

Unuseful comparison | IRRs are not reflected in full size in a portfolio

Return required to double an investment within 10 years (schematic diagram)

Source: Kaiser Partner Privatbank

Broad menu selection: Ranging from “not ideal”…

Being aware of the challenges of private markets is an important first step. Then an investor has to find a suitable means of implementing exposure to private markets. Investment minimums are no longer a major obstacle because nowadays access to private markets can be had for relatively small investment amounts. However, the ever widening spectrum of private-market offerings to choose from features better as well as less suitable options. We place investments in individual private-market funds or in portfolios of them that call and redeem investor capital at intervals in the latter category. These structures known as closed-end funds have been an established fixture in the institutional segment for decades, but implementing exposure to them is too complex and hardly manageable for retail investors, at least if they wish to truly reap the benefits of this asset category with their private-market exposure. Investors have to contend with the following challenges:

• Diversification: A successful private-market portfolio requires maximum diversification across vintages, regions, sectors, company sizes, and types of investments (primary, secondary, co-investment), as well as across the four private-market categories: private equity, private credit, infrastructure, and real estate. To attain that diversification, ongoing periodic capital commitments have to made to different funds in each sub-asset class. Despite low investment minimums for individual funds, the aspiration for wide diversification can require very high total investment amounts and can overwhelm an individual investor’s administrative and financial capacity.

Administrative burden | A private markets investment program requires institutional expertise

Rolling private markets investment program (schematic)

Source: Kaiser Partner Privatbank

• Reaching and maintaining the target allocation: Whoever would like to add a private-market component to his or her mixed investment portfolio needs to have a lot of staying power. Since capital call drawdowns occur over several years, it takes a long time to reach the desired target allocation for the private-market assets part of the portfolio. Once the exposure aimed for has been built up, an investor continues to face challenges because keeping this allocation in a predefined range is hard to do as a result of uncertainty about the timing of capital calls and distributions and thus necessitates corresponding expertise.

Arduous construction process | Long road to the target allocation

Admixture of conventional private-market funds (with capital calls) into a mixed portfolio

Source: Kaiser Partner Privatbank

• Cash management: With an investment in an individual private-market fund as well as after having set up a comprehensive and diversified rolling investment program, in both cases there is always a certain part of the capital that is not invested in private-market assets at any given time. That cash component has to be managed actively in order to keep opportunity costs as low as possible. Reinvestment risk, on the other hand, cannot be averted, not even with good cash management. Depending on the new investment opportunities available and the market phase at the time, there’s a possibility that returned capital cannot be reinvested at an equally high rate of return as before.

Opportunity costs… | …and reinvestment risk

Investment profile of a conventional private-market fund (with capital calls)

Source: Kaiser Partner Privatbank

…to investor-friendly and customized

Even though it may seem alluring to get in on the game at eye level with institutional players by investing in individual private-market funds operated by prominent names like Blackstone, KKR, Carlyle, and the like, given the difficulties described above, there actually are better ways for retail investors to invest in private markets. One way in particular is via evergreen funds, which have increasingly established themselves in the market in recent years. Evergreen funds allow investors to make an instant, widely diversified investment in private markets in a single ticket and provide partial liquidity usually on a quarterly basis. Since the investment made is in a portfolio that already exists, this not only reduces blind pool risk, but also nullifies the J-curve, making the desired target returns realistically achievable right from the start. Evergreens make private markets semi-liquid and enable access to them without forcing investors to take on a multiyear commitment. However, investors should be aware that evergreens nevertheless are not daily tradable ETFs and should bear in mind that they pursue an investment horizon of at least three to five years, as is appropriate for this asset class.

Kaiser Partner Privatbank has developed a comprehensive solution based on semi-liquid private-market funds that offers investors access to a private-market portfolio diversified across all asset categories. The Kaiser Partner Private Markets Solution aims for a long-term return of 10% to 12% per annum and lends itself as a supplement to an existing mixed portfolio or also as a separate satellite investment.

Custom-made and investor-friendly | Kaiser Partner Private Markets Solution in a nutshell

Comparison of conventional private-market funds versus Kaiser Partner Private Markets Solution

* simplified implementation possible

** majority redeemable within 6 months, full redemption may take 12 to 18 months

Source: Kaiser Partner Privatbank