Adding return and lowering risk with private assets

Before it listed on the stock market in 2004, Google had raised a mere $25 million privately. Today, there are companies raising more than 500 times that amount. Would Google (now Alphabet) list at such an early stage of its growth today? Not a chance.

The emergence and growth of private markets have played a pivotal role in reshaping how companies finance themselves. Investment strategies had to change too, but also how investors access the market.

Previously, only institutional investors had the keys to this opportunity but access is broadening, with increased participation from high-net-worth individuals and retail investors. Regulatory developments and product innovation have paved the way.

What’s changed?

In the US, over 300 companies a year, on average, joined the stock market between 1980 and 1999. Since, there have been only 127 a year. Alongside a lack of new entrants, M&A-driven de-listings have consistently reduced the stock of existing companies on the public market. The number of US listed companies has dwindled by nearly half since the 1996 peak. And this is the much-vaunted US market. Others are mostly worse.

Figure 1: Far fewer companies are listed on major stock markets than in the past

This is down to a combination of the increased scale of the private equity industry (which can now write bigger cheques) and an increase in the perceived cost and hassle of a stock market listing. Companies are staying private for longer and more of the returns are being captured by private equity investors. Investors who don’t incorporate private assets in their portfolio risk missing out.

In debt markets, there has also been a notable shift to private markets. The private debt industry has grown considerably, while traditional bank-lenders have stepped back from many markets due to post-financial crisis regulatory changes. This has provided an opportunity for private lenders to step in.

It’s important not to conflate private debt with direct lending. Many use these terms inter-changeably but the largest part of the private debt universe is asset-based finance, which is fundamentally different. Direct lending, representing about $1.7 trillion of loans, is private corporate lending. Asset-based finance, representing more than $13 trillion of loans, includes commercial real estate debt, infrastructure debt, consumer debt (auto loans, credit cards, student loans, etc), and receivables or lease finance. A key distinction is that asset-based finance is secured on, and repaid by the cashflows from, specific assets. Direct lending is repaid out of general corporate cashflow so is correlated with the corporate risk present in traditional bond portfolios.

What is the appeal of private assets?

1. Provide higher returns/income.

Private equity buyouts have outperformed US large and small caps by a significant margin (net of fees) over the long run. And private debt offers a yield pickup over corporate bonds. The secured nature of asset-based finance also helps to provide a more stable return profile than corporate bonds.

Figure 2: Private assets typically outperform, net of fees

Figure 3: Private debt offers a yield pick-up over public bonds such as high yield debt

2. Provide access to a broader range of exposures, industries, or outcomes.

The shift to private market financing means that investors can only access the full opportunity set by allocating to private markets. The sector and regional split of many public markets is also not representative of the characteristics of the asset class as a whole. This can skew outcomes. Infrastructure debt is a good example. The public infrastructure bond market is dominated by utilities and US issuers, whereas the infrastructure debt market is far more diverse by sector and region.

3. Reduce risk (volatility and/or risk of loss)

Returns from many private assets are less volatile than public markets, which appeals to many investors. However, in some cases, this is down to valuation methodologies, which can smooth reported price variability.

This is well known in private equity and real estate, but also occurs in private debt. For example, while some private debt holdings (including Schroders) are fully, independently, marked-to-market using prevailing market yields, others value at cost-less-impairment, and others use discounted cash flow style approaches.

Not all private asset classes or structures exhibit smoothed valuations. The assets in semi-liquid funds are valued monthly or quarterly in accordance with rigorous accounting standards, such as US GAAP and IFRS 13. To ensure these valuations provide an accurate picture of the fund's holdings, they are often audited by reputable audit firms and regularly reviewed by internal pricing committees.

Private assets are less volatile and they may also be less risky, but to assess that second point it is necessary to dig into the asset class, and strategy itself. There are many qualitative factors which need to be taken into consideration (see full paper for some examples).

A more holistic approach to understanding risk is required. Real estate risk is nearer to equities than bonds, despite what standard volatility analysis might suggest. Private equity is highly diverse. The slightly higher leverage in large cap buyouts means that it would be reasonable to treat the sector as riskier than public equities, but a qualitative case can be made for small and mid-cap buyouts to be given more favourable treatment. Individual venture capital investments may be risky, but portfolios have been remarkably resilient and can also gain in value even when markets are crashing. Private debt too is highly diverse. There are elements which are less risky than corporate bonds, especially in asset-based finance, but the spectrum is wide.

Figure 4: Private assets have different underlying risks to public markets

4. Add diversification benefits by introducing differentiated drivers of returns

Given their differing underlying exposures and return drivers, private assets offer diversification benefits compared to public markets. These vary by asset class and market. Given issues with valuation approaches, a better way to consider the relationship between public and private returns is to look through to the underlying exposures and focus on differentiated drivers of returns, not statistical estimates of correlation.

For example, large private equity buyouts returns are strongly influenced by public markets, but the relationship is much weaker in small and mid-cap buyouts and venture capital. Early-stage venture capital depends less on stock markets and the economy (as companies typically have no or low revenues and no earnings), but on progress in product development and initial customer wins.

Similarly, many infrastructure projects exhibit greater cashflow stability and less sensitivity to the economic cycle than the corporate sector so can diversify equity exposures elsewhere.

On the private debt side, direct lending has a similar risk sensitivity to corporate bonds (aka corporate risk premium), whereas asset-backed lending such as real estate and infrastructure debt, and consumer lending has exposure to the underlying cashflows from an asset or package of assets, so it is fundamentally different.

In terms of the relationship with interest rates and traditional bonds, more leveraged equity investments will be more vulnerable to movements in bond yields/financing costs than less leveraged investments.

The floating rate nature of much private debt also means that higher interest rates feed directly into higher returns, whereas higher rates lead to falling prices of traditional fixed rate government and corporate bonds. This makes much of private debt a fantastic stabiliser when volatility is coming from interest rates, and a beneficial partner to traditional fixed income exposure.

In summary, the ability of private assets to diversify existing public investments can be a major attraction. In assessing this, differentiated return drivers should take precedence over statistics.

5. Provide more direct exposure to impact investing

In recent years, an increasing number of investors have become focussed on the impact they have with their investments. Private markets offer distinct advantages for creating and measuring impact in a more precise manner than is possible in public markets.

In private equity, for example, significant equity stakes and board representation grant investors the ability to directly influence a company's trajectory, which can include alignment with specific impact. For real estate, place-based impact investing (PBII) has a focus on outcomes like job creation and improved housing. Private assets, particularly in sectors like renewable energy, affordable housing, and sustainable agriculture, often have a direct link to impact objectives such as the United Nations Sustainable Development Goals (SDGs).

On the debt side, a clear example of the alignment of investments with impact is microfinancing, whereby microfinance institutions provide loans and (increasingly) savings, insurance and related products to groups with low-income, as well as micro, small and medium enterprises. These enable income-generating activities and help people to break out of poverty.

Practical considerations

Increased interest in private assets has led to large amounts of capital being raised in the past decade. “Dry powder”, money raised but not yet invested, has hit record highs. High fundraising runs the risk of too much money chasing the same deals, higher prices being paid, and lower future returns. Large buyouts and direct lending are two of the hottest spots on this front.

Better opportunities can be found by seeking out less crowded markets and by using the credibility and reputation of an investment manager to gain access to deals that others would not see. Deal access has become one of the most important edges that a successful investor can lay claim to.

In addition, bigger transactions tend to be highly competitive, whereas smaller or more complex deals tend to be less so. An obvious example is a comparison between a private equity fund taking a public company private (by paying a premium to its public value) and a buyout of a family-run business with no other suitors.

In private debt, structuring is an essential skill, which presents a barrier to entry. This is especially true when dealing in less crowded areas where structure means more than just covenants.

One consequence of the greater scope for private asset managers to steer their investments is a wider dispersion of returns than is typical in public markets. The difference in return between top and bottom quartile buyout funds globally has been around 15%, on average. Manager selection is more important when investing in private assets.

Figure 5: The importance of fund selection in private assets

Private markets offer a rich variety of investment options which can diversify and enhance risk and return for investors. With their growing clout, more and more financing is taking place privately. Investors focussed solely on public markets risk missing out. There is no shortage of attractive opportunities but, with increased interest has come increased competition. Investors should seek out less crowded markets to benefit from the return and risk enhancement that private assets can offer.

Important Information

Marketing material for professional clients only.

The information in this document was produced by Schroders Capital which refers to those subsidiaries and affiliates of Schroders plc that together comprise the private markets investment division of Schroders.

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Issued in November 2024 by Schroder Investment Management Limited, 1 London Wall Place, London EC2Y 5AU. Registered in England, No. 4191730. Authorised and regulated by the Financial Conduct Authority.