Private markets: A way to optimise portfolios

Looking at the private equity market, Russel says over the last two decades, being in a listed environment has become extremely unattractive for medium-sized corporates, due to the costs and complexity of this environment. This has resulted in dramatic shrinkage of the listed market, with the number of listed companies in the U.S. falling by more than 50 per cent over the last 20 years. Today, listed markets are generally dominated by only a handful of mega companies in concentrated sectors, like technology. 

“In comparison, private markets have grown rapidly over the years. Today, the number of private market companies are significantly larger than listed market companies,” says Russel. “Therefore, investing in private equity enables investors to truly diversify across the global economy.”

According to Russel, over the last two decades, private equity has outperformed listed equities and has done so with lower drawdowns and volatility. “It’s no wonder then that the vast majority of institutional investors include a substantial allocation to private equity, alongside listed equities.”  

Similar to private equity, institutional investment in private credit has surged over the past 15 years. With banks largely exiting corporate loans, this has opened up the opportunity for private credit funds to capture this part of the market.

This has resulted in a supply-demand imbalance, with private credit funds being able to earn excessive spreads. According to Russel, the most attractive part of this market is bilateral lending (effectively, when a private credit firm lends directly to a corporate in a senior secured position) to mid-market companies. Pengana defines the mid-market as companies with EBITDA of $50-$250 million.

“And here’s the incredible thing,” says Russel. “A private credit fund can lend at a modest loan to value ratio (LVR) to a billion dollar-type company, which has plenty of cashflow and steady recurring profits, and can charge spreads of 5.5-6 per cent above the base rate. So, effectively, where rates are today, earning double digit returns.

“Due to the nature of these companies, the loss rates are likely to be extremely low. In addition, as the loans are not traded, there is very little volatility in their valuations. It’s not surprising that private credit is the most sought after asset class amongst global institutions and family offices.”

With such a compelling argument for private equity and private credit, why aren’t these asset classes more widespread across individual retail investment portfolios in Australia?

The reason, says Russel, is because there are several challenges with these assets that first need to be overcome. These include:

1. Diversification — Investors need to be diversified across managers, strategies, sectors, and geography. However, all the best managers have very large minimum investment requirements, making it very difficult for even large retail investors to get access to this type of diversification. 

2. Access — It is extremely difficult to gain access to the best funds, as most of these funds are only open to dealing with investors who they have established relationships with.

3. Capital lock-up — Most private market funds tie investors up for many years, with some taking more than 10 years to return capital. So, whilst an institutional investor can cope with this level of illiquidity, most retail investors find this untenable.

However, while conceding the difficulty to date for retail investors in Australia to access private markets, Russel says this is changing. The arrival to market of some best-of-breed solutions is enabling private market assets to become more easily accessible to investors — whether investing directly through platforms or managed accounts. “This will be a game changer for all portfolios,” says Russel.

When it comes to accessing high quality global private equity opportunities, Zivan Wong — Portfolio Manager, Private Equity at MLC — acknowledges it can be challenging tapping into the U.S. and European markets.

“At MLC, we tend to access opportunities in two ways,” says Zivan. “Firstly, through inbound approaches by private equity firms reaching out to MLC and secondly, the outbound work from our team in trying to find those hidden gems in the private equity universe.

“There is a lot of interest from offshore private equity firms looking to access capital in Australia. With Australian superannuation sitting at around $3.7 trillion, these firms recognise Australia is an important market in order to access the investor base of Asia-Pacific. Post-COVID, more overseas private equity firms are coming to Australia on a regular basis.”

MLC also spends a lot of time meeting directly with private equity firms in their home markets. Zivan believes it’s very important to maintain regular dialogue with these firms, as part of building a relationship, before adding a firm to the portfolio.

When accessing private equity, most managers typically look offshore to Europe and the U.S., but is there an opportunity to invest locally?

Russel concedes that Australia is a very small market globally, representing about 2 per cent of global investments. And while he says it’s possible to invest in private equity locally, it’s difficult to find investments or managers that invest in Australian private equity in the mid-market space.

“For mid-market investments, we believe offshore markets are better than the Australian marketplace. In Australia, there are far fewer opportunities and competition is fierce. However, there is significantly more opportunities in offshore markets.”

In contrast, MLC does have long-term relationships with a number of local private equity firms, with stable track records. Relative to the size of the Australian economy, Zivan believes there are a reasonable number of local private equity firms, making it a competitive market.

While being active in Australia, MLC also looks offshore, particularly to markets in Europe, like the U.K., Sweden and Denmark, which share many similarities with Australia.

“Like Australia, these markets are very supportive of the business environment for private equity. There is a strong rule of law, transparent access to information, and good regulation. There is also an attractive mix of exciting industries and sectors, which makes these markets very appealing for private equity investing,” says Zivan.  

As for private credit, Russel says offshore markets are far better than the Australian marketplace. He says in the U.S., banks generally don’t lend to the mid-market, which means private credit firms have this space to themselves.

A question often asked by investors is why do private equity funds either pay little or no dividends to investors? Russel acknowledges it’s a common misunderstanding that there are no cashflow distributions in private markets. Instead, dividend payments tend to be more sporadic in private markets.

According to Russel, both private equity and private credit funds typically start out with an investment period (where they are investing), in which they are not returning any dividends to investors. Over time, these funds will start giving back to investors, but this tends to be sporadic, as most of the underlying businesses tend to use their dividends to pay down debt.

“There is no consistency with investor dividends but in general, there is quite a large amount of cashflow coming back from these underlying investments. So, you can’t pick any single manager or any single investment and know what the returns will be. However, generally, you do know there is money coming back but it’s going to be sporadic.” 

Zivan agrees that cashflow is often used by these private equity firms to expand and reinvest in the business. He adds that some firms also like to have some defensibility by preserving cashflows, as was seen through the recent period of high interest rates.

“The fundamental screen for us when investing in private equity is the business needs to be cashflow generative in its own right,” says Zivan. “That’s an important consideration for us.”

When looking at opportunities in the private equity space, Zivan says there are a number of investment themes that MLC likes. One of these themes is the convergence of healthcare and technology, which will help to deliver healthcare to people in a smarter and more cost-efficient manner. Another theme it likes is global energy transition, as countries increasingly move to renewable energy.

“And artificial intelligence (AI) is another theme we’re seeing in private equity, particularly in relation to how firms are utilising AI to create better investment decisions. AI tools are going to become more prevalent within the private equity sector,” says Zivan.

In terms of private credit, Russel says the demand for private credit capital dramatically exceeds supply. And even though money is coming into private credit, it can’t keep pace with the amount of capital that is required. “So, we think this is an interesting space and certainly an investment opportunity for a number of years to come,” says Russel.