Why Invest in Private Markets

Why are investors becoming increasingly attracted to the private markets?

Investors are increasingly attracted to private markets. But first, what exactly are private markets? These markets involve investments in the equity or debt of companies that are not listed on a stock exchange and do not trade publicly. These markets present a broad array of opportunities, from global or regional private equity or debt to niche areas like natural, resources, infrastructure, renewable energy and real estate.

In recent years, private markets have experienced significant inflows, amounting to billions of dollars. S&P Global projects that the market will exceed $15 trillion by 2025 and surpass $18 trillion by 2027. Several factors are poised to fuel this growth, such as the shift toward a greener economy, a dynamic financial system and the conclusion of zero-rate borrowing. Additionally, a pivotal force behind the expansion and sophistication of private markets is new technology. By automating and digitising complex processes, technology has enhanced access, streamlined transactions and crucially, reduced the gap between private and public markets.

Now, what sets private markets apart from public ones? The key difference lies in liquidity. Private markets are less liquid and do not benefit from continuous secondary markets. In contrast, the public markets’ real-time liquidity can lead to price volatility. The trade-off for reduced liquidity is the potential for higher returns, known as the illiquidity premium.

The illiquidity premium is the additional return that investors expect as compensation for the reduced liquidity of their investments. This premium serves as an incentive for investors to take on investments that are more difficult to exit. While illiquid assets can potentially offer higher returns than their liquid counterparts, this is by no means guaranteed.

Why invest in private markets?

Simply put, private markets present a greater potential for reward. By investing in these markets, investors may earn a premium for accepting reduced liquidity. Since private markets require money to be tied up for extended periods, they often promise higher returns. Apart from the potential for higher returns, investing in private markets often helps to lower overall portfolio volatility. During periods of heightened volatility, valuations are typically more reflective of a company’s actual earnings, making them less susceptible to the external noise and investor sentiment that frequently impact public market prices. Moreover, there is notable investor dissatisfaction with public markets. Ideally, a country’s stock market should offer diversified exposure to its economy, yet many widely followed indices depend heavily on a small group of companies for their performance.

The diversity of investment opportunities in the private markets far surpasses that of the public markets. The avenues for private market investing are expanding as public market offerings diminish. Today, private markets have become a key component of an investor’s strategic asset allocation. A major factor behind this trend is the significantly larger range of investment opportunities in private markets compared to public ones. Globally, there are over 140,000 private companies with annual revenues exceeding $100 million, contrasted with just 19,000 public companies at the same revenue threshold (World Bank data as of 15/09/2023 – domestic listed companies). As companies are opting to stay private for longer periods, this is presenting more opportunities relative to the public markets. This decline makes diversification beyond public markets increasingly essential. Institutional experience indicates that allocations to private markets can serve as effective diversifiers, especially when the correlations between public markets tend to converge.

Given that private market investments have the potential to deliver higher, more stable cash flows over varied market cycles, it is hardly surprising that money inflows into the marketplace are rising rapidly. For instance, private credit investing utilises a broad range of strategies throughout market cycles, not available in public markets, potentially leading to higher returns than liquid public bonds.

A key strategy in private credit is direct lending, known for its low default rates. This is due to how these loans are structured, allowing private lenders to implement protective measures around a company’s assets to minimise default risk and maximise recoveries. Such loans often have floating rates, which help safeguard against rising interest rates, thereby providing a reliable income stream.

Many private market assets offer protection against long-term inflation risks. These assets often show stronger resilience in inflationary or rising interest rate environments. Private market strategies enable investors to focus on sectors and issuers that are likely to outperform during times of high and persistent inflation. Keeping a consistent allocation in private markets can diversify an investment portfolio, potentially improving risk-adjusted returns.

Contrary to the common belief that private market managers are indifferent to Environmental, Social and Governance (ESG) factors due to a lack of public scrutiny, they have been integrating ESG considerations rapidly, despite facing different pressures than their public market counterparts. This should not be a surprise since they are well-positioned to drive positive impacts given their close involvement with their investments, which allows them to leverage their influence over the investee companies or assets they hold. This influence, combined with direct access to information, makes it easier for them to encourage the adoption of good ESG practices compared to a minority shareholder in a public company. Further to this, privately-owned companies operate on a longer time horizon than publicly traded ones, providing additional support to a sustained ESG focus.

If an investor is not constrained by liquidity limits, is permitted to hold medium to long term investments and clearly understand the risks, with the right approach, a systematic allocation to private markets can greatly benefit investment portfolios by targeting enhanced returns and improving diversification. At the same time also opening-up access to a vast range of high-quality opportunities that are not available in public markets.

Author: Russell Hammerson, Principal Trainer| Finance Professionals Training & Development, ZISHI

As private markets grow in complexity, expertise in this area is more valuable than ever. For investors, professionals, and organisations looking to deepen their understanding of private markets and refine their strategic approaches, ZISHI offers a comprehensive range of training programmes. Discover how our tailored programmes can empower you to excel in private markets and beyond—contact us at info@thezishi.com.