Private markets myth-busting: Decoding the illiquidity/complexity premium
Rather than focus simply on liquidity, it’s important to understand and balance out all the risks in any portfolio. James Lowe talks to Citywire Wealth Manager about possible approaches.
High-profile cases involving open-ended funds with illiquid underlying assets have shone a spotlight on illiquidity risk for UK investors. This can be a deterrent for some when they consider private markets.
Private asset managers argue that, for their investors, illiquidity is an intrinsic part of the risk-return proposition – one that must be understood and managed from the outset, like any other investment risk. Ruling out private assets on the basis of illiquidity risk, they point out, could mean missing out on the premium that is paid for taking on that risk, as well as attractive diversification benefits. For instance, research shows that a significant part of the historic return pick-up in private equity has stemmed from the fact that unlisted companies tend to be cheaper to buy than their listed peers, because one can be sold easily while the other can tie up money for extended periods.
At the same time, private market returns can also depend on another important premium: essentially the ability to access and tackle complex situations, and the skill needed to execute these types of deals. This is known as the ‘complexity premium’. Negotiating these complex situations can often take time. Here, the value creation process can sometimes require a degree of illiquidity.
No such thing as a free lunch
A balanced overview of risk begins with the recognition that conventional portfolios are already likely to be exposed to a number of equally potent risks.
It is a basic axiom of investing that returns above cash can only be achieved by taking on a degree of risk. Traditional portfolio management seeks to balance out this trade-off by employing a range of assets with different risk-return profiles.
At one end of the spectrum, DM sovereign bonds have a low risk but historically muted returns. At the other end, emerging market equities may have the potential for strong returns, but this comes at the cost of taking on a variety of risks: political, sector, currency, and governance risks to name a few.
Public market risk vs private market risk
Just as there is a broad risk-return spectrum in public markets, private markets also span a range of categories. For example, private equity can be broken down into sub-sectors including venture capital, small-mid-large buyouts, growth, turnaround, secondaries and more. Each of these sub-sectors has different characteristics and PE providers note that these can compare favourably in terms of risk and return to a traditional public equity portfolio and point to the ways that UK institutions have incorporated elements of the PE spectrum in their portfolios.
The inherent spectrum of risks and returns is also visible across different private market asset classes. ‘In an area like UK renewables, for example, revenues are often underpinned by government contracts,’ said James Lowe, director, private assets, and investment trusts at Schroders. ‘It’s possible to invest in a portfolio of UK wind farms that gives a return higher than gilts, where there is a high degree of visibility of cashflows over the next ten or fifteen years, based on the contracts in place. Although these assets are illiquid investments one could argue that investment risk is relatively low.’
At the other end of the spectrum is venture capital, where investing in high-growth, early-stage private companies comes with illiquidity and where defaults are common.
‘Institutional investors have demonstrated that diversified private markets allocations can have significant long-term benefits to portfolio risk-adjusted returns,’ Lowe said. ‘Each individual will have their own unique views and ability to take on higher risk investments, with varying tolerances to illiquidity. It is important that this is assessed at an individual level on a case-by-case basis. That said, new private market fund structures in the UK are providing more flexibility to private client wealth managers as to how they incorporate private markets, with a range of liquidity profiles, into portfolios.’
Public markets beta: A key risk factor
One of the more visible risk measures present in investment portfolios is volatility. Private markets can, under the right circumstances, be an effective diversifier of returns, Lowe explained. This is because the underlying assets of many private markets funds have different drivers to those in traditional listed markets.
However, it has been difficult until recently for many investors to access this benefit. Historically, the main access route into private markets for non-institutional investors in the UK has been investment trusts. These offer daily liquidity, but their listed status also means that they are subject to short-term price movements and the ebbs and flows of market sentiment. This is demonstrated by the fact that many have moved from premiums to significant discounts to net asset value (NAV). There is an argument that if held over the long term, then the end investor experience should be closer to the NAV. But the reality is that the investor is beholden to the price at the time of selling which will depend on prevailing market conditions, Lowe said.
‘For investors who have a genuine long-term investment horizon, such as high-net-worth and pension savers and can therefore likely take on a degree of illiquidity the new long-term asset fund (LTAF) structure gives an additional option to invest in private markets via a structure that is priced at NAV, rather than market price,’ Lowe said. ‘The institutional experience has shown that private markets allocations can be a helpful diversifier, particularly in times where public bond and stock correlations tend closer to one. When used as part of a strategic long-term asset allocation, the LTAF structure could prove to be an important additional tool in helping individual investors to achieve greater diversification and potentially a return pick up on their public market portfolio.’
This piece first appeared on Citywire Wealth Manager on the 3rd of June 2024.
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