Investing in Private Markets
Investing in private markets can potentially increase financial returns and social and environmental impact for those willing to tolerate the risk. There are new opportunities for individual investors and family trusts to make such investments.
In their Global Private Markets Review 2024, McKinsey states, "With private market asset classes outperforming their public market equivalents over the past decade, individual investors and their financial advisors are seeking incremental private market exposure to improve the absolute returns and increased diversification". The report notes that the entrance of retail investors into the private markets landscape is one of the most significant structural shifts in this private market area in recent years.
Most New Zealand retail investors are familiar with investing via managed funds in the shares of companies listed on the NZ, Australian or international sharemarkets and companies' debt or fixed interest. However, they are less familiar with investing via managed funds into specialist private market investments – the shares and debt issued by privately owned non-listed companies – than 'public' listed companies.
Investing in private assets has been a long-time interest of mine. I was involved when the NZ Venture Capital Association (NZVCA) was established in 1986. In association with the NZVCA, I helped teach in 1986 and 1987 the first course of this type at the University of Auckland. In 1987 I also created and presented my course through my business in association with what is now the Auckland University of Technology (AUT). A vital part of these courses was fund managers explaining what they were looking for in prospective investments and giving feedback to course participants. The NZVCA later rebranded to become the "NZ Private Capital Association" and continues to play a key role in "Accelerating Sustainable Ambition".
The domain of private assets in NZ has been chiefly for "wholesale investors". The Financial Markets Authority (FMA) explains that: "Wholesale investors are defined in law and, broadly speaking, are people or organisations who have sufficient previous investing experience that means they don't require disclosure". The FMA notes, "Wholesale investment offers can promise attractive returns but don't have the same protections as retail investment offers. Wholesale investment offers are aimed at experienced investors, often with large sums of money to invest. Unless you are a very experienced investor, you should proceed with caution and talk to a financial adviser before investing in a wholesale offer". For further insight, see this article from the FMA titled "Spotlight on Wholesale investing".
Recently, I've been happy to see the emergence of managed funds that Money Matters can consider for inclusion in plans and portfolios for "retail investors". The Financial Markets Conducts Act states that: "A person is a retail investor, in relation to an offer of financial products, the supply of a discretionary investment management service, or any other relevant transaction, if the person is not a wholesale investor in relation to the offer or service". Funds offered to retail investors must meet the FMA's requirements, including a Product Disclosure Statement (PDS). The FMA requirements offer retail investors further protections than what is required for funds offered to wholesale investors.
In our latest podcast, I discuss this subject with Cameron Brownjohn, CEO of the Australian-based Federation Asset Management. Federation has created a fund for retail investors to access private markets. The Federation fund does not invest in venture capital. A global fund manager has recently made its fund that includes venture capital available for retail investors in New Zealand (contact me for information about this). The global fund includes the three categories of private assets discussed below.
What are Private Assets?
Cameron suggest investors ought to view 'Private Markets' as particularly unusual. He notes that many people have experience of creating wealth through owning a business or property. Discussed in this way Cameron maintains that 'Private Assets' is "just allowing access to a portfolio of more of those types of investments for people". The Federation website includes reference to 'Growth Equity', 'Buyouts' and 'Deep Value & Turnaround':
'Growth Equity' involves investing into businesses in their growth phase who require an injection of capital to fuel growth, such as expanding overseas. In the case of Federation, they may invest in partnership with a founder, entrepreneurial management team or family who have built the investee company to the level of success it has achieved at the point of Federation's investment. In this way, Federation's capital is intended as 'growth equity': providing the investee company with its next injection of equity capital sufficient for it to achieve its next phase of growth. The Federation team believes the following formula produces good prospects for investment returns, regardless of industry or the type of company: "where the investee company has a point of difference, which in turn gives it a defensible market presence; sells products and/or services that fill a social and economic need; and has a culture and way of business that is consistent with Federation's responsible investing principles".
'Buyouts' involve buying the existing owners shares with the existing owners leaving the business often over a transition period of a few years. In the case of Federation, they discuss aiming to invest for "control of established cashflow positive companies in market segments where Federation possesses a strong, long-term track record; deep knowledge base; excellent and broad investment sourcing networks and capabilities; and vast experience with strong execution skills including due diligence".
'Deep Value & Turnaround' involves investing in the turnaround phase of the business lifecycle with a sound business model but underperformance due to solvable factors. For Federation, these are 'Special situations', where Federation will consider rescue capital and turnaround situations, again in market segments and in situations where Federation has a defensible edge and deep experience.
Why Invest in Private Assets?
1. Expected Higher Long-Term Return
Private assets offer the potential for higher expected returns. For example, the McKinsey Global Private Markets Review 2024, published in March, states: "With private markets asset classes outperforming their public market equivalents over the past decade, individual investors and their financial advisors are seeking incremental private markets exposure to improve absolute returns and increase diversification." The report notes that the entrance of retail investors into the private markets landscape is one of the most significant structural shifts in recent years.
Cameron provided the following account of returns:
Over the last ten years, the average annualised rate of return on the NZX50 accumulation index is 8.8%. That's pretty good. For every dollar that was invested, it went up by nearly 9%, annualised return, including dividends, over the last 10 years. However, the local industry association for private equity, recently published that the results of the average private equity fund that's been operating in New Zealand and Australia has achieved over the same period. It's not 8.8%, it's 18%. The average, run-of-the-mill private equity fund achieved 18% return. A bit over double the rate of return that the listed market achieved over the last decade.
He suggested "all other things being equal, if these rates of return were to persist into the future (of course, past performance is not a reliable predictor of future performance. But let's imagine that those same rates of return existed), if you had an investor that wanted to invest, pick a number, $20,000 today. At the rates available on the NZX50 over the past decade, that $20,000 would grow to $46,000 in 10 years. At the rates of return that the average private equity fund has achieved over the last 10 years, if that was to continue, it wouldn't be worth $46,000 in 10 years, it would be worth $105,000 in 10 years.
Your listeners may ask themselves, would they rather have $105,000 or $46,000? Of course, return-seeking is a key reason to invest in private equity."
2. Potential social and environmental impact
Private markets investment has potential to make a significant social and environmental impact. Federation’s website refers to “ESG (Environmental, Social and Governance) friendly investments” in healthcare, technology, financials, sustainable infrastructure, social real estate and other sectors”. Cameron said “We are a believer that if you invest in an ESG-savvy way, you're more likely to protect your investors' capital and to grow it”.
Quantifying benefits Cameron said “Our wind farms have an annual carbon abatement of 770 million trees…We have childcare facilities built or being built for 10,000 kids…The last company that we exited (sold after investing earlier), is a health care business that is all about drug trials for cancer and renal dialysis. Our investments are in things that make a difference to the world”. He continued:
From a purely selfish, hard-nosed, capitalistic financial perspective, the world likes those things. The world needs those things and they need it more today than they did yesterday. The value of those things, we think, when you think about long-term time horizons, like private equity investors do, the value of those things should go up.
I'll give a hypothetical example of the reciprocal. Let's say, for example, a coal mining company. A pool of buyers that want to hold a coal mining company is smaller today than it was two decades ago. The pool of buyers that want to hold a wind farm company is larger today than it was two decades ago. Supply and demand, if nothing else, of the investor universe, supports the valuations and should grow the valuations of our companies, leaving aside that the output of these things, things like the energy being produced by wind farms, or being stored by batteries, or the need for child care facilities as more women enter the workforce… our boat is floating on a rising tide.
3. More investable opportunities
Cameron maintains that one of the reasons for investing in private assets is that they offer more opportunities. "There is a really large canvas to paint on. There is in fact more investable opportunity by far than there is in the listed market. For example, private equity firms like Federation, can buy listed companies, we can privatise them, we can buy unlisted companies, we can buy your house, we can buy the office block next to it and so on and so forth. The investable landscape is not restricted to just the things in, for example, the NZX50 accumulation index or the broader New Zealand Stock Exchange. It's everything else that can be done with capital in New Zealand."
4. Opportunity for a more strategic, longer-term approach
Cameron suggested that some of the characteristics of Private Assets can reduce the risk of individual investments. He argued, "The listed market generally focuses on a shorter time horizon - quarterly earnings results, semi-annual earnings results, or market variances. Whereas the private equity industry tends to think in far longer time horizons. If you're less focused on what's around the corner, you're more strategic in how you're allocating capital and how you're strategically driving your portfolio or the underlying investments. It should follow that actually over a longer period of time, there's an argument that it's less risky, not more risky. I think that's starting to be borne out in even the academic research on some of these topics."
5. Likely less correlation
Most listed share funds will have more assets than a Private Asset fund and, therefore, a greater spread of the risk associated with individual companies failing. Index funds may range for hundreds to thousands of individual shares, and active funds often have at least 50 shares. From this perspective and definition of risk, there is often more risk in Private Asset portfolios with fewer companies or other investments.
However, a crucial part of risk management via diversification is that the less correlated investments are, the lower the overall portfolio risk will be. Cameron uses this factor to make the case for Private Assets: "There is evidence that there's a relatively lower rate of correlation to the sorts of return profiles that you might achieve on the listed market. For example, the price of your home may be less volatile or may not necessarily trade in the same way as the price of a stock on the NZX50. There may be some correlation, but not 100% correlation. So, it is with any other private equity or private asset class."
What are some of the disadvantages of Private Assets?
It is important with any investment to consider the disadvantages. Private assets are no exception to this investment rule. What follows is some but not all of the disadvantages that investors need to understand and be comfortable with before investing in Private Assets.
1. Liquidity Risks
Private assets are typically much less liquid than public securities and generally considered illiquid. One definition of “illiquid” is that these assets are usually not easily sold or exchanged for cash without a substantial loss in value. Selling these investments can be challenging and time-consuming, often requiring a long-term commitment, which can be a significant drawback for investors needing liquidity who may need to sell at a loss.
The McKinsey Global Private Markets Review 2024 describes how, with more retail investors interested in this area globally, fund managers who are used to committed, long-term institutional investors now need to find a way to provide some liquidity or allow retail investors to access their money.
Cameron reiterates that private asset funds should be considered as an illiquid investment. Federation offers redemptions of units, but this is limited per calendar quarter to 5% of the number of units outstanding at the end of the preceding quarter. The Federation literature describes how "If the 5% limit is reached for a quarter, withdrawal requests for Units over the 5% limit will be taken to be cancelled. The trustee has the right to discontinue redemptions or vary the timeframe for payment. Should a large number of investors of the Fund decide to redeem, the Fund could be forced to liquidate investments prematurely, causing losses to the Fund".
Cameron explained that "the private equity industry, not just Federation … has come up with this 5% of the fund value available every quarter. Partners Group, one of the global private equity funds out of Switzerland, they offer this service; Schroeders, one of the global firms, similarly offers this service; Hamilton Lane, out of the United States, with their products for the Mum and Dad investor universe, offer this service. Federation as a regional, local example, offer this service. In every instance, it's 5% of the fund value available for redemptions each quarter".
Liquidity can be supported where applications to invest in a private assets fund exceed redemption requests. Private asset managers may also hold more cash than the 5% per quarter level potentially required to fund redemptions required. If considered necessary and fair to remaining investors, the manager could use this additional cash to fund redemptions.
This liquidity issue can be accounted for in a retail personal investor's plan and portfolio by considering it as money they can afford to lose. For those with long-term horizons (i.e., a minimum of ten years) and an ability to tolerate the risk of investing in private assets, a modest allocation to private assets need not be precluded on the basis of illiquidity.
2. Higher Fees
Private asset funds often have much higher fees than managed funds investing in listed assets. One reason for these higher fees is the more costly, complex investment decision-making processes.
Listeners to the podcast have told me they were fascinated by the extent of research involved in selecting Private Assets. In our interview, Cameron explains the Federation research process in more detail. By way of summary, Federation's literature describes an investment process with an "emphasis rigorous fundamental research into each investment opportunity, Powerful origination capabilities, and that Risk management and capital protection is a critical focus."
Federation describes using a three stage Investment Committee process for any new investment, variation or sale of an existing investment
Initial Investment Committee: Approves whether considering an investment is a good use of time
Formal Investment Committee: Approves whether to spend money on due diligence (or sale costs for exits)
Final Investment Committee: Approves whether to execute binding transaction
They note that from 800+ opportunities originated with an over AUD$20bn transaction value, Federation reviewed 130 opportunities reviewed (with an over AUD A$7bn transaction value). Of these 22 opportunities went through Federation's detailed due diligence, and 8 investments were made.
To invest in a fund with private assets, most investors would expect the higher fees to be more than compensated for by the expected higher return. By way of example of how the fee issue has been considered in a New Zealand context, the Ministry of Business, Innovation and Employment (MBIE) weighted fees at 30% in the 2014 KiwiSaver default provider appointment review. In their legal opinion titled 'KiwiSaver investing in private assets' discussed below, the authors encourage an express acknowledgement that "value for money" could include delivering better long-term value for KiwiSaver members by investing in private markets (Venture Capital and Private Equity) and infrastructure assets (where the product positioning and SIPO of the particular KiwiSaver fund allows).
3. Concentration Risks
A key principle of risk management within investment is diversification to reduce what is known as “concentration risk”. It is important to consider concentration risk in the context of private asset funds as these are more concentrated than funds that invest in hundreds or thousands of public assets.
Most listed share funds will have more assets than a Private Asset fund and, therefore, a greater spread of the risk associated with individual companies failing. Index funds may range from hundreds to thousands of individual shares, and active funds often have at least 50 shares. From this perspective and definition of risk, there is often more concentration risk in Private Asset portfolios with fewer companies or other investments.
In my ‘Essential Guide to Financial Planning in New Zealand’ (CCH, 2000) I explain a number of the risks of portfolio concentration including:
Firm specific risk which refers to factors which may affect a company’s returns which are unique to it. These may include the loss of key personnel, a strike, a new discovery, natural disaster and so on.
Industry specific risk which refers to factors which may affect the returns of all firms in an industry, but affects firms in no other industry. These may include changes in tariff protection; new safety standards, the release of new technology, changes in pattern of consumer demand and so on.
Local market specific risk which refers to factors which affect all firms in an economy. These may include changes in the inflation rate and the economic growth rate, foreign currency fluctuations, government tax legislation and so on.
Diversifying investments into different firms, industries and economies can have the effect of smoothing out the returns from the portfolio. Holding an internationally diversified portfolio can smooth away the effect of firm, industry and local market specific events. However, market wide events which reflect the price of all assets cannot be smoothed away.
Similar issues of increased risk and the need to diversify apply within cash, fixed interest and property investment.
4. Complexity
Many aspects of evaluating private assets are more complex than with public assets. For example, the valuation of private assets is more complicated and involves more subjective judgment and assumptions because of limited comparative data and benchmarks. Public asset valuations are reflected in real-time prices. Private assets lack this dimension of valuation, which can lead to greater discrepancies between perceived and real value. These complexities can make it difficult for investors to fully understand the risks and true value of their investments.
5. Operational and Management Risk
Investments in private companies carry risks associated with management effectiveness, operational issues, and sector-specific challenges. These risks can be more pronounced than in diversified public companies. These risks are heightened by less transparency and arguably more significant influence of management teams characteristic of private markets.
Why does New Zealand lag behind Australia in funds investing in Private Assets?
In article titled 'Sustainable investment: Overcoming barriers to KiwiSaver providers investing in private assets' Lloyd Kavanagh, Partner and Claire Brabant, Senior Associate at law firm MinterEllisonRuddWatts, reflect on how "less than 2% of the approximately $100 billion in total value of KiwiSaver funds are invested in unlisted shares, far less than retirement savings scheme providers in other jurisdictions, e.g. 18% of Australian superfunds in private assets". Lloyd was a former colleague when we were both on the board of the Securities Commission (now the Financial Markets Authority (FMA)). He is quoted as saying "New Zealand trails well behind other countries, such as Australia, both in the proportion of retirement savings invested in private assets, and the returns earned by those retirement savings".
Another MinterEllisonRuddWatts publication, 'The untapped potential of KiwiSaver funds in the M&A market', notes that Australian investment entities with more than six members invest, on average, 4.9% in unlisted equities. They report that private equity makes up approximately 4% of the New Zealand Superannuation Fund's investment portfolio. Commenting on the small number of fund managers in New Zealand investing in private assets, they provide examples of exceptions where one is investing 10% of funds under its management in private assets, and another is investing 5%.
The Centre for Sustainable Finance: Toitu Tahua (CSF) contrasts the very low exposure to private assets in KiwiSaver schemes to date with global patterns where retirement savings funds in many countries are significant investors in less liquid asset classes: "G20 governments plan to rely more on private investment to develop green and transformative infrastructure. Institutional investors, such as pension funds, are expected to double their allocation to private market assets over the next five years, with non-listed infrastructure investments likely to increase substantially. By contrast, that will not be the case in Aotearoa New Zealand unless historical patterns in KiwiSaver investment change".
The CSF states: "The majority of KiwiSaver investors have long investment horizons (20 years +), but they have little option to take advantage of their long investment horizon by way of investing in private markets. This means many New Zealanders aren't benefiting from investment options that can provide potentially higher financial returns and may also bring long-term positive environmental, social, and economic outcomes." The CSF published its Investing in Private Assets Recommendations Paper, which provides recommendations for KiwiSaver managers and the government to reduce the barriers preventing KiwiSaver funds from investing in private assets.
CSF recently commissioned leading law firms, Chapman Tripp and MinterEllisonRuddWatts, to provide a joint legal opinion on the legislative and regulatory barriers that may be contributing to KiwiSaver's low rates of investment into private assets. Co-author of the legal opinion and Partner at Chapman Tripp, Tim Williams said: "Private asset investment won't suit every investor, nor will it necessarily be something all KiwiSaver providers offer, but some investment choices present in the broader New Zealand financial markets, and internationally, are not being provided through current KiwiSaver scheme options, narrowing the risk and return diversification choice available in the KiwiSaver scheme universe, including the opportunity to provide needed capital for New Zealand's development. It is worthwhile exploring why this is, and whether improvements can be made."
Next Steps
If you want to learn more about investing in private assets, please listen to my podcast interview with Cameron. Special thanks to Cameron for taking the time to visit Auckland and undertake the interview in person at the studio. There is extensive other information available online, including in the links above. You are encouraged to consult with a qualified financial adviser with an understanding of private assets to help you consider this information, your situation and the investment options before including these funds in your plan and making any investment decisions. If you'd like to learn more from me, please be in touch.
Disclaimer: This content provided in this blog is for informational purposes only and should not be construed as investment advice or an endorsement of any specific investment product or strategy. Any references to specific investment products should not be considered as recommendations to buy, sell, or hold such investments. You are encouraged to consult with a qualified financial adviser before making any investment decisions. Money Matters does not endorse or recommend any specific investment products or services mentioned in this blog. Past performance is not indicative of future results. Investing involves risk, including the potential loss of principal. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed. Always consider your own financial situation and risk tolerance before investing in any securities or investment strategies.