This is a very relevant question that one needs to consider from a South African as well as a Global perspective, as there is definitely a growing investor awareness and appetite for Private Market asset classes. Globally, there is a lot of data backing this up that one can analyse and we have tried to highlight a few trends in this article.
Private Equity. As a subset of Private Markets, it is probably the most well-known asset class as its net asset value has grown more than sevenfold since 2002 on a global basis, twice as fast as Global Public Equities. It is also interesting to note how American (USA) PE-backed companies have grown from 4000 in 2006 to around 8000 in 2017, which translates into a 106% increase. Meanwhile, US publicly traded companies fell by 16% from 5100 to 4300 (and by 46% since 1996). Even some large investors that had previously stayed away are now allocating to Private Markets, seeing asset classes like Private Equity as necessary to get diversified exposure to global growth.
Globally (and in South Africa) Private Debt funds are now filling a financing void for many middle-market and sponsor-owned companies, providing security structures avoided by banks due to changing banking regulation over the last decade. Investors are becoming more familiar with these types of funds and their portfolio allocations have steadily increased in the last decade as depicted in the graph below.
Infrastructure. Private Market allocations globally to infrastructure expanded appreciably in 2018. This is due to a secular trend: both public and private infrastructure spending (on roads, power, airports, bridges, tunnels, ports, water, and telecommunications) has grown at 4.2% annually in recent years. Most sectors, including transport, power, water, and telecom, are on the rise, in both developed and developing economies. The current trend that we are seeing should continue as it is estimated that at least $3.5 to $4 trillion of annual investment is required through 2035 to keep pace with economic growth. In addition to strong long-term demand, traditionally defined infrastructure tends to be less correlated with Public Markets and provides some hedge against economic uncertainty and inflation, given that many of these assets have a contract structure or regulatory construct that enables inflation costs to be passed through to customers. Attractive returns relative to fixed income assets (the typical comparable for infrastructure assets) are also helping drive capital into infrastructure.
From a South African perspective, this is also true as there is more and more noise being made about the Renewable Energy Independent Power Producer Programme (REIPP), which has been a very successful Public Private Partnership, should be extended to fill the broader infrastructure need for South Africa. This might still take some time to take shape but it is clear that the South African Government will be looking to the Private Sector, which is broader than the SA Banking system to help finance a growing infrastructure need. The above has been evidenced by the following:
In September 2018, President Ramaphosa announced that the Government would set up a South Africa Infrastructure Fund in a bid to transform its approach to the roll-out, building and implementation of infrastructure projects, with a contribution in excess of R400 billion from the fiscus over the medium-term expenditure framework period. As part of the reprioritisation of spending, additional infrastructure funding will be directed towards provincial and national roads, human settlements, water infrastructure, schools, student accommodation and public transport.
Private Market value creation
Source: Andreesen Horowitz
A very real way that one can also look at Public vs Private Market value creation is in the US Technology sector as a lot of companies are staying private for longer. It is important to note that Public Markets are not being shunned but its role is merely changing from being pools of Risk Capital to Pools of Liquidity. Private Markets are therefore growing and fueling the bulk of the growth for these companies.
What are the main reasons for allocating to Private Markets?
An asset class allocation evolution is definitely taking place and investors are opting more and more for Private Market assets. Globally the reasons for choosing various Private Market asset classes might vary but the main reason is accessing diversification.
Additional reasons are, however, given if one breaks it up for the various asset classes:
Global portfolio allocation to Private Markets
Private Markets allocation globally can range from 10% to 40% of the portfolio depending on individual investor objectives, conviction in the ability to pick top-performing alpha-seeking managers, risk tolerance and annual cash flow needs which is in stark contrast to the low allocation that South African institutional investors have thus far allocated to these asset classes. Global asset owners, from sovereign wealth funds to endowments, have steadily upped allocations to Private Markets in the hunt for higher returns and to diversify away from Public Markets because Private Market asset classes have evolved considerably and are now offering exposure to a broader array of industries, geographies and capital claims. The same asset class availability evolution is also taking place in South Africa as more and more investment houses are entering the Private Market arena.
I started following David Swensen, the Chief Investment Officer (CIO) at Yale University, around the time that his book, “Unconventional Success: A Fundamental Approach to Personal Investment” came out in late 2005. It has also been fascinating to see how Yale’s investment approach has held up even through the Global Financial Crisis when it received a lot of criticism from the financial press for its allocation to perceived high risk asset classes. For the fiscal year ended 30 June 2018, the endowment earned a USD 12.3% investment return. During the past decade, the endowment earned an annualized USD 7.4% return.
The Yale financial report also provides for interesting reading as it gives a clear breakdown of how the portfolio is currently constructed and also states why they have systematically increased the allocation to Private Markets since Mr Swensen took over as CIO in 1998.
“The heavy allocation to non-traditional asset classes stems from the diversifying power they provide to the portfolio as a whole. Alternative assets, by their nature, tend to be less efficiently priced than traditional marketable securities, providing an opportunity to exploit market inefficiencies through active management. Today’s portfolio has significantly higher expected returns and lower volatility than the 1988 portfolio.”
Additional reasons for allocating to Private Markets?
The decision to allocate to Private Markets can also go beyond expected returns. Additional reasons may include sustainable investing goals and accessing emerging markets where public markets are thin. It is also important to note that other investor objectives or constraints, such as the regulatory considerations of insurers, can matter more than the potential return premium over public markets.
What are the sticking points when investors think about Private Market assets?
In conversations with clients, liquidity, lack of deployment, complexity and fees are probably the topics that come up most as sticking points that detract them from investing more into Private Market asset classes.
Liquidity. Private Market asset classes are definitely less liquid than Public Market assets, but they are not as illiquid as investor automatically think. A few examples to back this up are:
1. Private Debt funds can be structured to facilitate liquidity:
- Monthly pay-out of interest to the investor.
- The fund can be self-liquidating, meaning that loan amortisations or maturities are paid out to investors as and when they occur.
- A liquidity facility can be provided to the investor for a portion of their investment in the fund. The above all lead to a vastly improved liquidity profile for the investor, if they so choose.
2. Private Equity investment in secondary investments also improves the liquidity profile of a private equity fund as the time to realisation of the underlying portfolio assets is much shorter.
3. Some Mezzanine financing funds have a bias towards transactions that are mostly contractual interest bearing in nature which has the benefit that the investor enjoys the pay-out of interest on a semi-annual basis rather than a back ended equity-based return profile.
Lack of Deployment. As a starting point, one needs to acknowledge that Private Market assets need to be originated in the primary market, meaning that they are not acquired via an exchange like the JSE. This point therefore makes it all the more important that the fund manager has a strong asset origination team that has access to various internal or external resources to help with asset origination. However it has to be assumed that Private Market investors will invest committed capital efficiently pending any potential drawdown, and this does partially offset the impact of slow deployment. In addition, fees for the fund manager should be lower until committed capital is deployed which also ensures better alignment of interest between all parties.
It is also important to note that asset origination is directly linked to the economic activity of the country, which implies that asset deployment is far harder in times of low economic activity. This point should therefore be taken into account by the portfolio manager when raising a new Private Markets fund to limit this risk as far as possible.
Complexity. One needs to concede that the legal contracts supporting certain Private Market asset classes are more complex than what investors, especially those that have thus far invested solely into the Public Market arena, are used to. The standardisation of say an en commandite partnerships (mostly used by Private Equity or Mezzanine funds) have, however, definitely occurred in the last decade and the leading asset consultants have definitely been part of this evolution and are therefore in a position to advise their clients fluently when it comes to these asset class investments. Another mechanism to consider is the use of Linked Policies as investors are vastly more familiar with them.
Fees. In a global low return environment, fees are more and more of a sticking point, especially if the perception is that one pays high fees but the net return generated are similar to say an indexation product. However, as the Yale example shows, significant alpha can be generated by investing into Private Market assets, and the research involved in producing this alpha is worth paying for. Having said this an evolution has, however, definitely occurred when it comes to fees as they have generally been lowered, innovative fee structures have been introduced, and alignment of interest between the investor and manager have been vastly improved in the last decade – gone are the days of the standard 2/20 model. Investors do need to understand what they are paying for, and in the main it is important to remember that the portfolio manager needs to originate assets (primary market asset origination) rather than trading or investing into listed assets (secondary market) which is far easier to access.
What does all of this mean?
It is clear that on a global basis, more and more portfolio allocation is being made to Private Market assets due to their various benefits. If one was to bring it closer to home, at a recent SA industry conference the Minister of Trade and Industry, Mr Ebrahim Patel delivered an inspirational keynote address on how “Partnerships with Retirement Funds can Boost Economic Growth”. Mr Jacko Maree, a member of the President’s Task Team of Investment, also gave an inspiring speech but in essence both gentlemen emphasized:
- Government’s lack of resources to accomplish all the infrastructure upgrades that are needed to assist the country in its need to deliver economic growth and job creation;
- Government’s desire to work with the private sector to provide for infrastructure needs;
- That Private Market asset classes such as Private Equity, Venture Capital, Private Debt and Infrastructure have been underutilised to date by SA pension funds and that pension funds were ideal investors to invest in longer term, private asset classes that can all contribute towards the growth of South Africa and job creation; and
- That Government would urge institutional investors to come on board voluntarily as Government does not want to impose a prescribed assets environment on the market.
We would augment this sentiment by adding that SA investors can now access an array of Private Market asset classes and funds that are already fully catered for by Regulation 28 and BN90 via CIS funds. These funds/asset classes are not meant to replace the investor’s Public Market allocation to Fixed Income, Public Equities and Cash but rather to complement it, especially in the current low return environment.