Private markets have been presented as the golden ticket to many of the questions swirling around the UK in the past year: How will investors contend with the number of companies opting to stay private? How will green initiatives continue to move forward? How will investors find diversification as equity and fixed income synchronise in returns?
The industry has leaned quickly and heavily into private markets as an answer. Research from MSCI found that 82% of wealth managers intend to expand their allocations to investments in private assets in the next three years.
And the finance industry isn’t the only believer: the UK government has also placed their bets on private markets, with Chancellor Rachel Reeves announcing PISCES in 2024 and the FCA debuting the Long Term Asset Fund in 2021.
Understandably, retail investors want in on the fun. But some, including Morningstar strategist Kenneth Lamont, warn that private markets come along with red flags.
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The long-term hesitations around private markets have largely surrounded liquidity. By nature, private funds require investments over many years to have enough time to alter businesses if needed and generate returns. Some of the new structures around private assets, such as LTAFs, attempt to create liquidity to become more palatable to investors.
But Lamont believes the attempt to bring private assets to a more liquid structure raises concern.
“There is no magic bullet that makes illiquid things liquid,” Lamont said. “It’s a mirage, in the sense that you can’t miraculously make something that is illiquid liquid without some extra cost. Those costs might be passed into structural risk and perhaps tucked away into core costs you don’t quite understand.”
To qualify as an LTAF, 50% of the fund must be held in illiquid assets, but another part of the fund must be liquid to allow for redemptions. The funds are required to have a 90-day notice period around redemptions and provide quarterly reports to investors.
However, the guidelines around LTAFs remain, for the most part, broad, and have yet to been seen largely in practice.
Alex Funk, CIO at PortfolioMetrix UK, said: “People always tell you they understand liquidity until they need liquidity. The ability to ask for something and then be told no is something you have to physically go through to really understand what that means.”
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Funk notes that this is not the first time that a largely illiquid product has caught the eye of investors. Open-ended UK property funds led to frustration as investors asked for redemptions that were not readily available. The issue led to an FCA consultation in 2020 due to a “liquidity mismatch”, and resulted in the advent of the LTAF.
“Believe it or not, you couldn’t sell the Gherkin overnight,” Funk said.
“Now you have this issue where you have more ask for your money versus what you could supply. First, the gating started. And the unhappiness in the industry went through the roof even though everyone had understood this principle before.”
The LTAF is designed to protect against these issues. But Lamont worries that it then compromises one of the main appeals of the funds: the returns. While private markets have gained popularity for their attractive returns in recent years, in a structure where funds are forced to hold some level of liquidity, those returns will be diluted.
Currently, Lamont said there is a preference in the market for evergreen structures, which do allow for quarterly entries and exits, but have certain restrictions around them. These investments are also required to have an amount in the fund that is highly liquid, which Lamont said often translates into a large amount of the investment essentially being held in cash.
In addition to questions around liquidity, there is also the matter of how the assets themselves are being priced without being publicly traded.
“One of the big attractions from the private markets is they’ve had higher returns and higher risk adjusted returns, and some of that is already a mirage. Some of it is because the pricing of these assets is infrequent, so who are you trusting to be the one to give these accurate prices?” Lamont said.
“There is no actual price if they haven’t traded, and suddenly you’ve got the smoothing of risk. There are structural issues that you maybe can never overcome, because there isn’t actually a price sometimes.”
In a report for the CFA Institute, author Ludovic Phalippou, professor of financial economics at Oxford, raises the issue of since-inception internal rate of return (IRR) as the preferred metric for the industry, which he believes has skewed the view of the sector’s results. For anything that is publicly traded, performance is easy to track, with an opening and closing price each day. But because private equity is not traded daily, they rely on other metrics, such as since-inception IRR. Phalippou argues that this can turn a few years of impressive returns at the beginning into what seems like a long track record of continuously impressive returns, because of how the data is reported.
Steve Croucher, commercial officer of Winterflood Business Services, said: “The price of the private market company can be problematic as there is no ongoing market and therefore a lack of data to know what is a fair price.
“There are companies that are using good techniques to address this and following best practices aligned with listed companies. However, at the other end of the spectrum some firms only publish information annually and even that can be limited in details.”
Yet, from an asset management perspective, interest in private markets makes sense. The government is keen to stimulate the economy, and in a period of few IPOs, private assets become an important piece of the puzzle.
Funk recognises that private assets come along with an attractive base case.
“I think it’s all around this theme of democratisation of private assets for retail investors. I appreciate the base case for why that makes sense. A lot of companies are staying private for longer because a lot of stockmarkets are potentially not rewarding companies for listing. And there is access to all this private funding, so you don’t need the complexities around listing and the additional expenses in order to generate more capital,” Funk said.
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“It’s a capital raising exercise, and if I can get that outside of the listing requirements, then, so be it.
The market also presents a possible area of success for active investors, who have been forced to compete against indexes when it comes to public markets.
“If you can sell something with higher fees, and you can operate in less efficient markets where there’s more of a premium, perhaps you can harvest that premium. Then there’s obviously a reason to be entering into that market,” Lamont said.
“In the traditional fund universe, the price pressure is unbelievable. They’re highly efficient. We are seeing a lot of consolidation in that market, just simply because it becomes a scale game, and it’s very difficult to outperform if you’re an active manager in a lot of those spaces. So it’s absolutely logical to try and sort of shimmy along and towards the private side of things which have higher margins, more complicated markets, and there is potentially an informational advantage to a better manager in that space as well.”
Despite concerns around the market, Lamont said there is potential for private assets to act as a benefit as further developments are made.
“We do see this coming together. We do expect more effort and ideas being merged. But these are reasons why you should be sceptical if you’re an investor, and it’s quite possible that this is just a mirage, that by the time it lands on your plate as a retail investor, the benefits of that those private markets have evaporated in front of your eyes, and you’re left holding nothing.”
This story was written by our sister title, Portfolio Adviser
