As private assets become a commodity, will it diminish returns?

By Tom Bradley

Private assets are becoming a large part of the investment landscape and, like their public brethren, are steadily being commoditized. Funds are available to a broader range of investors, including individuals, and transacting is easier than ever.

There’s more change coming, but first let’s look at how public and private markets got to where they are now.

The road to zero

Investing in stocks and bonds today looks nothing like it did prior to 1975 when trading commissions were fixed. Before deregulation, the cost of trading was outrageous, mutual funds were expensive niche products, and indexing wasn’t a thing. Back then, company and market data were the exclusive purview of your broker.

Now, trading commissions are near zero and there’s a fund for every purpose, some of which trade on the market (ETFs). You can gain broad market exposure almost for free, and as for information, disclosure regulations and the internet have given individuals the same access as institutional investors and advisers.

In the shadows

The model for investing in private assets is well established. A firm raises money for a fund with a term of 10 to 12 years. It buys businesses in the first three to four years with hopes of increasing their bottom lines so they can be sold at a profit in the last two to three years. After the proceeds are distributed to unitholders, they do it all again.

Investors sacrifice liquidity and transparency for the potential of higher returns and less quarter-to-quarter volatility.

Private fund managers have two big advantages in generating those returns. First, they operate outside the media spotlight and quarterly reporting cycle, so they can make hard decisions and give the resulting strategies time to play out. And second, they use debt more liberally, which lowers taxes and amplifies returns.

But there are tradeoffs. It costs more to invest in private businesses. Deals must be sourced, due diligence done, bids won, businesses managed, and exit strategies executed. All these steps must occur during narrow windows of time, regardless of market conditions.

Private assets for everyone

Industry veterans like to reminisce about the good old days when private investing had few players, even fewer spectators, and the strategy was simple. Buy private companies at low earnings multiples, cut costs, and take them public at significantly higher multiples. It was a beautiful thing. Savvy investors buying businesses from owners who had limited options and selling them to less sophisticated investors.

But those days are over. The industry is now awash with capital and dominated by megafirms that are investing privately at scale. Every deal has multiple players at the table, and public markets are more skeptical buyers.

And it’s not as illiquid as it used to be. To appeal to more investors, there are evergreen, or perpetual, funds, which are marketed as being “semi-liquid.” Investors can buy and sell at certain times under certain conditions.

Meanwhile, companies are staying private longer. Instead of going public or being sold to an industry buyer, they’re being traded from one fund to another. Alternatively, managers are creating continuation funds so they can keep companies beyond the life of the fund, because they still have plenty of potential or aren’t yet saleable.

What’s next?

Where private markets go from here is unclear, partly because big variables like transparency, liquidity, fees and returns are interdependent.

For example, the progress made on transparency (it’s all up from here) will depend on what liquidity is offered. If people can trade in and out, funds will be forced to reveal more and value their portfolio companies more frequently. This will likely result in private returns mirroring public markets more closely.

Where the industry goes on liquidity will be important. It’s the biggest challenge to widespread adoption but also the biggest impediment to performance. The recent drive to make private assets more accessible may slow as a growing number of funds struggle to accommodate redemptions.

As for the princely fees, I’m not optimistic that the Wall Street billionaires will share the benefits of scale with their investors. It will take an extended down cycle to shift the bargaining power to the buyer.

The biggest question about private assets, however, is whether the industry’s growth aspirations will diminish its structural advantages and reduce returns. Certainly, the presence of sophisticated investors on both sides of deals, an abundance of time-sensitive capital, and less shelter from the demands of hyperactive investors, suggests it will be more difficult for private assets to deliver the premium returns of the past.

Tom Bradley is a portfolio manager with Purpose Investments, co-founder of Steadyhand Investment Management, a member of the Investment Hall of Fame and a champion of timeless investment principles.