For a long time now, investors have been keen to increase investments in private markets outside stock-exchange markets. The trend held up until 2022. As the values of listed equities and debt securities plummeted in 2022, many institutional investors' allocations to private markets rose above target levels as listed securities fell in value. Many were compelled to go easy on future private market investments. It will take some time to strike a new equilibrium.
Returns available outside stock-exchanges
Institutional investors have been increasing their private market allocations for a couple of decades. It has been happening in all sectors. Typical investments include private equity, venture capital, infrastructure, real estate investment funds and private credit funds, which is a new growth market.
The growth in these investments can be explained in several ways. An important explanation is most likely the healthy returns on the investments. Low and decreasing interest rates have made it possible to use debt leverage to increase returns. Moreover, assuming that the investments have been made in the United States, the country has offered a better operating environment for companies.
To many people’s surprise, investments in private equity funds were profitable as late as 2023, real estate investment trusts being the only funds generating negative returns. Much of future performance will depend on interest rates. If interest rates remain at current levels, it will make it more difficult to arrange for refinancing or the fixed-term interest rate hedges will expire. What is more, overall stock market developments will also be directly reflected in the pricing of private equity funds, as the peer group valuation is based on values on the stock exchange.
Effect of rising interest rates
The interest rate environment has changed with the rise in rates. Hence, future returns on illiquid private investments will be determined by movements in interest rates. Each new day of high interest rates aggravates the situation. At one extreme are real estate and venture capital investments, in which the interest rate is the key discount factor.
At least for the time being, infrastructure and private credit investments have been spared from inflation and rising interest rates. The reason for this is that the income flows are tied to inflation, or the loans carry a variable rate of interest.
Private markets
Is there any significant life outside the stock-exchanges? The US stock exchanges have a market capitalisation of USD 50,000 billion, while private equity funds are worth USD 3,900 billion, according to McKinsey's estimate. Hence, private equity funds represent around 8 per cent of the public equity market. In the United States the private credit funds are worth around USD 700 billion, while market based corporate bond financing totals USD 21,000 billion. Corporate debt financing provided by banks stands at USD 2,700 billion. Although the private financial market outside of stock-exchange is growing, it is still relatively small.
In McKinsey’s estimate, the total global private fund market is worth USD 11,300 billion. Blackstone, the biggest player, has USD 1,000 billion in assets under management, much like a large US or European bank.
Room for improvement
As it is, the private market is still a fairly recent development. It grew in popularity step by step, driven by a number of factors. Sound stock market returns and falling interest rates encouraged investors to look elsewhere for returns. Asset managers developed new products in response to the growing demand.
An eternal problem affecting the private markets is individual treatment in terms of law and taxation. Private market investment products have not been standardised to the same extent as mutual funds (e.g UCITS). As a result, each investor needs to assess the investments from a technical and legal point of view, which investors in mutual funds are not called upon to do. In addition, cost structures are still prohibitively high, but as healthy returns have outweighed higher costs, there is little pressure to change things. What is also new is that much of the private market activity is already attracting the attention of the authorities supervising financial markets.
In conclusion
The private markets have been growing at a brisk pace. While this is expected to continue over the coming years, the current interest rates will bring the growth to a temporary halt. A pause is welcome as it will push weaker performers out of the race. Successful players will continue to grow if investment returns support growth. The sector will come under real fire when returns fail to compensate for the high costs. Even so, this illiquid market will continue to enjoy the advantage of smaller volatility in value compared to the public markets.
Writer is VER's CEO Timo Löyttyniemi.
