Long before there were exchanges for publicly-traded stocks and bonds, there were individuals who funded new business ventures and expeditions to find new markets and products. Today’s private markets funds are the inheritors of this entrepreneurial legacy.
Simply put, private markets encompass several asset classes and multiple strategies that invest in companies and assets that are not traded on public exchanges.
Private equity (PE) investment involves buying an equity stake in a non-public company, finding a way to increase the company’s value, and then profiting from an exit. This exit is usually via an initial public offering (IPO), a direct sale, or some other “liquidity event” like a merger. Investors are paid with proceeds from those exits. PE funds are broadly grouped into two categories: buyout and growth equity.
Venture capital (VC) funds provide investment for early-stage companies that typically have high revenue growth potential. Venture capitalists usually take a minority equity stake, investing alongside entrepreneurs with the ultimate goal of substantially increasing the company’s value and a profitable exit. Investors receive returns from these exits, which might be an IPO or a private sale of the fund’s stake.
Private credit is lending that happens outside of traditional banking and is not tradable on public markets. Lenders and borrowers negotiate private loans that span a company’s “capital stack” - the various tranches of debt on a balance sheet, ranging from senior-secured loans to unsecured debt. Borrowers run the gamut from blue-chip companies to startups. Prominent strategies, each with their own risk-return profile, include: leveraged loans, middle-market secured lending, mezzanine lending, asset-based lending, distressed debt, and special situations lending.
Private real estate funds (as opposed to REITs) invest directly in privately-held properties. The funds vary widely in terms of underlying assets, type of investment (debt or equity), and investment strategy. Strategies are typically divided into (from lowest to highest risk): core and core-plus, value-add, and opportunistic, which may include distressed assets. Core is most focused on generating regular income, while opportunistic strategies may seek returns from capital appreciation.
Infrastructure funds invest in the development and maintenance of essential systems, such as water, transportation, sanitation, pipelines, electrical grids, and other resources necessary to society. The fund may acquire and manage an asset, or provide financing for its development and maintenance. Infrastructure projects are typically classified as either greenfield (undeveloped) or brownfield (existing facilities). Returns typically stem from contractual payments for managing assets - which are often inflation-protected - or value appreciation, depending on the strategy.
Alternative investments and private markets?
There is some confusion about what differentiates private markets from alternative investments. Alternative investments, though a little fuzzy as a definition, tends to include anything that is not public stocks or bonds. Examples are hedge funds, commodity trading funds, fine art, wine, and even cryptocurrency. Put simply, private markets are a subset of alternative investments (see chart).
In the past 20 years, private markets have evolved and grown substantially (see chart below) to meet the changing needs of businesses - and have become much more accessible in the process.
Young and innovative companies are staying private longer as funding and fund managers’ capabilities have expanded - at the expense of public listings. Public securities are now just the tip of the iceberg of the investable universe: only 14% of companies with revenue greater than $100M are publicly traded.1
Private markets fund managers do not just fund innovation, they innovate themselves - creating solutions to new economic and financial challenges. For example, when the Great Financial Crisis (GFC) of 2008-2009, with its bank failures and heightened US regulation, left many businesses stranded in a lending desert, private credit managers stepped in and filled the void.
Increasingly, wealth managers are diversifying away from traditional 60/40 public markets portfolios, adding private markets strategies to clients’ portfolios to better achieve their goals. These goals are fundamentally the same no matter what you are investing in - one or more of growth, income, and/or risk reduction.
The various private markets asset classes can potentially help you better achieve these goals. In addition to adding diversification benefits, they feature characteristics that may allow them to:
Generate income
Boost risk-adjusted returns
Reduce correlations to markets
Provide downside protection
Hedge against inflation
Dan Feder, of the University of Michigan endowment, talks about what private markets can add to a portfolio
The bottom line
Of course, while these asset classes can play varying roles across a portfolio, the bottom line is if you are going to pay more than in public markets (and you generally will) you need to know that returns will be strong enough to justify that expense.
Over the 10 years through March 31, 2023, the median returns from growth-focused private equity and venture capital funds have exceeded those from active US equity funds after fees. Meanwhile, the median returns from income-focused infrastructure, private credit, and real estate funds have, on a net basis, beaten those from US public bond funds.
However, the potential range of outcomes from investing in private funds is quite different from investing in a mutual fund. In the private markets, performance is more deeply tied to manager selection.
A mutual fund holds a portfolio of publicly-traded securities. Those companies - and the fund - are required by law to disclose information in a uniform way. There are no disclosure exceptions and failure to comply with US Securities and Exchange (SEC) regulations carries severe penalties. It also means that mutual fund strategies can theoretically be replicated by a competitor.
This is not possible in private markets - each fund is unique, given the limited number of parties in each transaction, the high number of potential investment opportunities, the lack of standardized information, and differences in deal access. These are also some of the reasons why the potential range of outcomes from investing in the private markets is so wide.
Most investors access private markets through a fund structure. But it is important to note that these are very different from mutual funds.
Unlike with public markets - with fund and ETF ratings available from many different sources - evaluating private managers can be challenging. Furthermore, accessing in-demand funds may not even be possible for individual investors. There is also extra administrative work involved when investing in and managing private markets investments.
The elevated risk, evaluation challenges, and limited access create a compelling argument for a fund-of-funds approach, or potentially a custom fund vehicle built to your exact requirements, which allows you to leverage the networks of an established fund investor, provides additional diversification, may help reduce downside risk, and should alleviate administrative burdens.
There are also important structural differences in how you invest in private markets.
First, these are unavoidably long-term investments - these are usually “closed-end” funds with ten-plus year lifespans - and during that period you cannot easily exit your investment.2 This illiquidity can be a challenge, which is why you need to think carefully about what share of your portfolio you can afford to lock up for a sustained period.
David Barnard, Chuck Davis, Gideon Berger, and Hemant Taneja on incorporating illiquidity into your portfolio
Most private markets funds also take a “just in time” approach to collecting your money. Committed capital is the money you agree to invest in a fund throughout its life (read more here). Called capital is the money the fund manager collects from you as and when it makes investments (read more here).
You get capital calls throughout the investment period. This means you do not have to provide all the money upfront, but you will need to have ready cash for when there is a capital call. These calls can come with little notice and you need to respond quickly.
Private markets fund fees are structured differently from the flat fees you pay for a mutual fund. While they vary across the different asset classes, they are designed to incentivize the fund manager to do their best. There are two main types of fees, as well as some general expenses. We talk about this in more depth here, but in short…
There is an annual management fee that covers most of the fund’s basic operating expenses. This includes salaries, office rent, legal and due diligence costs, and other administrative costs. There is a performance fee that gives the fund manager a share of the fund’s profits, commonly called carried interest or just “carry”. The standard carry is around 20%, but it may vary depending on the terms of the fund agreement.
Carry is often subject to a hurdle rate. This means that performance fees only start to be charged after investors get their capital back plus the pre-approved hurdle rate.
As in any other investment, you can lose your money. As discussed, there is a much wider range of outcomes in private markets than in public markets - and if you end up at the wrong end of that range, it may mean capital losses for investors and managers alike.
Traditional private markets funds are also unavoidably long term and illiquid, which carries an opportunity cost for investors, while the lack of daily reporting may take time to get used to.
Nevertheless, we would argue that with careful fund selection, private markets can play a highly constructive role in achieving specific long-term goals. Private markets investments offer exposure to unique, genuinely exciting opportunities, as well as the ability to diversify both the 60 and 40 components of a traditional public market allocation, which should improve the resilience of your portfolio.
Still curious? View our Insights site for much more information on private markets.