Private Fund Category Expands for High Net Worth Investors
The stock market has shrunk and not just in terms of this year’s drop in price.
From 1998 to 2019 the number of U.S.-listed public companies dropped by over half to less than 4,000 according to The World Bank. The number has rebounded some recently, but it remains far below the level of 20 years ago. Meanwhile GDP has more than doubled.
While the thousands of present-day public companies provide a seemingly large set to choose from, they pale in comparison to the over 20,000 private companies with revenue over $100M as estimated by private equity firm Hamilton Lane.
And there are reasons to believe that the private market opportunity set offers higher long term returns in addition to more companies.
Nobel prize winners Eugene Fama and Ken French showed that in the aggregate stock in smaller public companies provides higher returns. Today, smaller companies are the most likely to remain private as growth in venture capital and private equity have allowed firms to delay or completely avoid an initial public offering.
Smaller firms have embraced staying private as the growing cost of going public deters IPO plans that require expensive squads of attorneys, accountants, and other professionals. As a result the average size of an IPO has ballooned and the number of unicorns - startups valued over $1B - has grown from 4 in 2009 to over 1,000 this year according to CBInsights.
All told, this suggests that more small company wealth creation is occurring in private markets.
The ongoing annual cost of being public averages $2.5M according to a study by EY. For a company doing $100M in revenue on a 10% profit margin, staying private equates to a 25% higher profit per year. It’s worth considering if the higher manager costs of investing in private companies balances with the avoided expense of being public.
Comparing the major public and private market players won’t allay concerns of adverse selection to public markets. Passive investment strategies like index funds now make up approximately half of all public market funds. These funds do not actually analyze the merits of individual stocks in which they invest. Such strategies are almost completely absent from private markets.
If a firm has excellent prospects, they may benefit by seeking investors willing to consider those prospects rather than passive funds blindly spreading capital. This arguably would lower their cost of capital. The opposite would hold true for a firm with a dubious outlook.
For most high net worth investors, exercises in comparing public and private markets have been futile for the last few decades because private market funds only worked with endowments, pension funds, and other very large investors. This has changed as some of the most storied private market managers have become broadly accessible to accredited and mass affluent investors. In most cases, these investors still must have a personal financial advisor to gain access.
Private equity, private real estate and private credit categories have all seen some of the top managers open funds with lower barriers to invest. Blackstone, KKR, Blackrock, and Ares now offer vehicles with minimum investments starting between $2,000-10,000.
These four and many other mangers now also offer funds with simpler, more timely tax reporting than traditional funds. The newer funds are mostly structured as “evergreen” funds with an indefinite life like a mutual fund. Private Equity and Venture Capital funds have historically been structured as finite funds where all investors participate for the entire time period. That traditional structure avoids the sticky issue of how to price the fund’s investments.
Access and some redemption rights are typically offered monthly on the new evergreen funds. Investors should consider possible discrepancies between public and private pricing. For example as of mid 2022 many publicly traded REITs are currently down approximately 20% from their peak, while private REITs have barely budged.
This suggests now is not the time to put money into evergreen funds. If the price hasn’t yet been marked down to reality then new investors are buying a piece of the fund’s unrecognized losses. Someday this process will work in reverse and create an opportunity for buyers.
In the long run, investors will want to allocate to funds expected to improve total portfolio investment results. One benchmark of the possible reward of investing in these funds the long-term return earned by CalPERS in its private equity program: 11.5% after fees since starting in 1990.
Investors would be wise to look for long-term evidence of better returns driven by a repeatable process when selecting a manager.