ACCESSING PRIVATE MARKETS 1.1 Private markets fundamentals

This video explores the growing world of private market assets (also known as "alternatives"). In particular, you'll learn about the different types of private market investments, their opportunities for investors and the potential benefits and risks.

Bryan Favilla

Director of fixed income markets at Capital Group

3MINVIDEO

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Bryan Favilla. Director of fixed income markets at Capital Group

 

There's a lot of excitement about investment opportunities that go beyond the traditional categories of public equities and fixed income.  

 

We're talking about private markets, where the investment landscape is growing every day. Rapidly evolving market trends and new product offerings have made private assets more appealing and accessible to a wider population.  

 

So, what do you need to know before exploring these options with your clients? We'll dive into all of that, but first, let's outline the basics of alternative and private investments.  

 

From private credit to private equity, real estate, infrastructure and more, there are plenty of private investment strategies that could potentially benefit your clients by diversifying their portfolios and improving their outcomes.  

 

As a trusted financial advisor, it’s important to be informed about these expanding opportunities, identify who they may, or may not appeal to and address risks and suitability concerns. 

 

We're here to give you a stronger understanding of private markets so you can discuss them with your clients.

 

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When we talk about private assets, we're going beyond traditional, publicly traded stocks and bonds, into the world of alternative investments, sometimes called "alternatives” or simply “alts.” We prefer to refer to these more as private markets or private assets.

 

Private markets encompass a wide range of asset types and strategies. Common types of private investments include: 

 

Private equity investments in private companies not listed on public exchanges. Private credit, which consists of loans made to private borrowers from non-banking entities. Real assets or tangible investments like real estate, infrastructure and natural resources and hedge funds where pooled investor money uses derivatives and leverage to generate returns.

 

Why are private markets appealing? Even though they have risks, they carry a potentially greater opportunity for reward than traditional public market investments. Adding them to a portfolio can diversify your investor’s holdings across a broad opportunity set. 

 

Of course, they're not without risk. Depending on the asset, they can be complex, opaque, illiquid and difficult to access, with potentially higher fees in the short and long term. 

 

Because they’re typically less liquid than traditional investment options, private assets are better suited for long-term investment. Since they’re not traded as actively, properly valuing them can be difficult.

 

There’s plenty more to learn about private markets and ways you can unlock access to these markets for your clients. 

 

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A closer look at alternative investments

 

Alternative investments are financial assets that don't belong to the traditional categories of public equity, public fixed income or cash equivalents, among others. They are commonly referred to as “alternatives” or “alts.” (For simplicity, we’ll use those shorter variations, too.)

 

Four main categories of alternatives

 

Private markets investments cover a wide range of investments with unique characteristics. Definitions of alternative investments vary, but they can generally be grouped into these four broad categories: 

1. Private equity

Private equity includes equity investments in private, non-listed companies. Types of investments include, but are not limited to: venture capital, growth equity and leveraged buyouts. They seek higher growth and diversification relative to traditional equity markets. 

 

Typical investment objective: Growth

2. Private credit

Private credit refers to various forms of debt that do not involve a traditional bank and are instead originated directly between private lenders and borrowers. Types of investments include, but are not limited to: secured direct lending, asset-based finance and mezzanine debt. Private credit may offer the potential for higher income and lower duration.

 

Typical investment objective: Income

3. Real assets

In contrast to financial assets, investments in real assets involve direct ownership of tangible, nonfinancial assets such as real estate, infrastructure, timberland, farmland and commodities. They can offer investors the potential for capital appreciation and income, while seeking to mitigate inflation risk over time.

 

Typical investment objectives: Growth, income, inflation protection

4. Hedge funds

This is a private investment vehicle used to implement a wide variety of strategies spanning public and/or private investments. Hedge fund strategies include long/short equity, merger arbitrage and global macro, among others. Broadly speaking, their aim is to deliver enhanced risk-adjusted returns, help manage portfolio volatility and help provide uncorrelated sources of return. They can often use derivatives and leverage more extensively than mutual funds.

 

Typical investment objectives: Growth, income

Potential benefits

 

Private markets may help your clients pursue their long-term goals and objectives and can be an attractive complement to traditional stocks and bonds. Alts represent a broad range of investments that may fulfill multiple roles in a portfolio, including:

 

Enhanced returns and income generation

 

Private markets have the potential to produce attractive relative returns and yields compared to traditional asset classes. It is important to remember these investments carry their own risks.

 

Diversification 

 

Adding private market investments that are less correlated with traditional investments within a portfolio of stocks and bonds may potentially diversify risk exposures. 

 

Expanded opportunity set 

 

Shifts in public-private market capital formation have resulted in a large and growing set of new investment opportunities not typically found in traditional public investment options.

 

Inflation protection 

 

Private market investments backed by real asset collateral, e.g., real estate, have the potential to offset inflation risk to a degree when the collateral has appreciated with inflation. Investments in private markets may offset inflation risk to a degree when their floating rates automatically adjust when nominal rates rise.

Investor risk considerations

 

Private market investments can vary tremendously in their accessibility and structure, but they typically share several key risk considerations:

 

Greater complexity 

 

Private markets can require specialized knowledge and can add tax complexity. Strategies may use leverage, which has the potential to magnify returns and downside risk.  

 

Limited transparency 

 

Private markets tend to have fewer regulatory reporting requirements and may not always offer the same level of transparency as traditional public investment offerings.

 

Barriers to entry 

 

Regulations generally only permit marketing and distribution of private markets investments to investors who meet certain qualifications. This generally shuts out investors who fall below the qualified investor requirements. In addition, private market investments may require greater tax compliance and reporting as compared to traditional public investments, which can be a large administrative burden.  

 

Valuation challenges 

 

In the absence of a mark-to-market price, alts are often “mark-to-model,” which involves assigning estimated values based on complex financial models. As a result, prices aren’t updated frequently and are subject to appraiser discretion.

 

Low liquidity

 

Most private market investments are illiquid and typically can’t be easily bought or sold, making them more suitable for long-term commitments. Depending on the strategy and vehicle type, investors may not be able to redeem the entirety of their investment for multiple years.

 

High minimum investments and fees 

 

Many private market investments have high minimum investment requirements and fee structures, such as performance fees and carried interest, compared to traditional investments.

Helpful criteria when choosing an alternative investment 

 

If you’re considering alts for your clients, thorough qualitative and quantitative due diligence is required and includes, but is not limited to:

 

Investment team and firm 

 

What’s the team’s investment experience? What’s the firm’s culture and areas of experience? How good is their track record across all strategies and services?

 

Investment vehicle strategy and investment process 

 

What’s the manager’s investment strategy — and how do they use leverage, short positions and derivatives? Does the manager offer strategies that aim to enhance liquidity and bring about greater diversification because they merge public and private assets?

 

Risk management

 

What risk management protocols are in place to help independently ensure that monitoring is objective and effective? Are risks deliberate, well-balanced and aligned with established investment guidelines?

 

Pricing and valuation practices 

 

Is pricing separate and distinct from the investment team? Is a third-party valuation agent or administrator used? Are valuation inputs consistent? Is there a formal and comprehensive internal process to assign appropriate values to the investments?

Checkpoint

Now that you have completed this lesson, you should be able to confidently:

 

  • Define private market investments and distinguish them from traditional public investments.
  • Identify the four main categories of private market assets and their typical investment objectives.
  • Assess the key benefits and risks of private market investments, including considerations for retirement income, diversification and liquidity.

Takeaways

Private markets: An emerging investment opportunity for individual investors

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End of Lesson

The next lesson will dive into public-private solutions and how these address typical private market challenges. 

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