Episode 16 – The Case for Private Markets

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Welcome to Market Perspectives, a Mercer Advisors podcast. Today’s episode is the case for private markets. I’m Josh Zumbrun and I’m the Director of External Communications here at Mercer Advisors. And I’m joined by Don Calcagni, our Chief Investment Officer. Don, thanks for being here today.

Great. Thank you, Josh. It’s great to be here.

Private markets are a really broad category of investments. They’re defined by what they’re not. Private markets are the universe of investments that are not publicly traded. It’s a huge range of things. It ends up being more things that are in private markets than are in the publicly traded markets.

It’s a bigger universe of things–

private equity, venture capital, hedge funds, private real estate, private credit. Whether you’re new to the concept of private markets or looking to deepen your understanding of the topic, there’s a lot of material to go over here. But before we dive into what private markets are exactly, let’s step back and talk about what’s our goal as investors that leads us to care about this in the first place. So, Don, before we get into private markets, define the problem that we’re trying to solve as investors.

I think it’s important for us as investors to remember that what we’re ultimately solving for is earning returns, the highest returns possible, with the lowest amount of risk, such that we can achieve our family’s long-term and short-term financial objectives, Josh. And so when we think about building diversified portfolios, that’s all about reducing risk. Diversification is how we build portfolios that are lower risk.

At the same time, we also want to make sure that we’re earning the highest returns possible. And so this conversation around private markets, the primary incentive here is that private markets over long periods of time have demonstrated an ability to outperform public market investments by quite a bit, sometimes as much as 6% or 7% annually, over very long periods of time. And so the attractiveness that those higher returns, higher potential returns offer to investors is something that we’re looking to incorporate into more broadly diversified portfolios so that investors can more easily achieve their long-term financial objectives.

Now, I think when a lot of people hear diversification, the first thing they think of is a broadly diversified portfolio of publicly traded stocks. They think of an index fund. They think of the S&P 500. This is what people were taught diversification means.

And over the long run, this has been a good approach. And so I think the question a lot of people are naturally going to have is, did something change. Why are we talking about going beyond these broad diversified portfolios of public stocks?

Yeah, it’s a great question. And I think it’s important to keep in mind that diversification is a spectrum. Not all forms of diversification are created equal. So, for example, a portfolio of 10 stocks, publicly traded stocks, is more diversified than a portfolio of just one stock.

Now, to take it a few steps further, diversifying beyond US stocks to include European stocks, or Japanese stocks, that is what we call asset class diversification. So you want to diversify across asset classes and you want to diversify within asset classes. Asset classes are types of investments that behave in a certain way. They tend to move together somewhat in unison.

So think of energy company stocks or Japanese financial stocks, they tend to behave very similarly. There’s nothing wrong with building a diversified portfolio that consists exclusively of public stocks. However, what I would caution is that, for example, if we look at the S&P 500 index, which in theory owns about 500 US large company stocks, that index has become progressively less diversified over time.

Why? It’s what we call a capitalization-weighted index. So the size of the companies in the index are more heavily weighted than, for example, smaller companies in the index. So for example, today, the S&P 500 index about 35% to 37% of the index consists only of about 10 companies today.

And that’s the most concentrated that it’s been in many, many decades. And so the S&P 500, while itself is diversified, is relatively less diversified today, Josh, than it was in years past. When we’re talking about investing into private markets, what we’re talking about doing, fundamentally, is adding different asset classes to our portfolios to diversify beyond just diversifying within public markets.

Don, let’s double-click on that and look at that a little bit deeper. The key point there I think is that something is changing in public markets, that public markets are actually a little bit different than they used to be. What are some of the other dimensions to that?

I think it’s important to acknowledge that public markets are always evolving. They’re always changing. Since 1896, when the Dow Jones was created, public markets have continued to evolve. And Josh, the way they’ve evolved here over the past couple of decades is we’ve actually seen the number of publicly traded stocks actually shrank, so much so that today, there’s only about 3,500 companies that are publicly traded in the United States.

I think at its peak, it was over 6,000 or 7,000 stocks, as recently as the late 1990s. So we’ve seen a shrinking of the number of publicly traded companies in the market. So that’s the first thing I would highlight. There’s fewer investment opportunities on a relative basis in public markets than there were in years past. Additionally, if you look at the popular indexes that so many investors today invest their 401(k)s in, for example, the S&P 500, like we were just discussing, those indices are becoming more concentrated in fewer and fewer companies, such that the relative amount of diversification has been declining with time.

That statistic on the number of stocks, we’ve looked this up before the show, so there’s this index, the Wilshire 5,000. It was called the 5,000 because when it launched in the 1970s, there were about 5,000 companies in the United States. And in the late 90s during the dotcom boom, all the companies going to IPO, there was a peak of 7,800 publicly traded companies. And it’s now fallen to about 3,500, like you said. So it’s fallen by more than half.

It’s a really remarkable decline. And obviously part of that was what happened with the dotcom bubble. And some of those companies maybe shouldn’t have been IPOs in the first place. But nevertheless, the amount of opportunities you have has declined significantly. And the amount of companies that are available in that early stage, I think we’ve seen has declined as well.

Absolutely. And I think–

if you think about what feeds the public markets, it’s the private markets. So historically, if you were a startup company, you would build your company, you would raise capital from venture capitalists, or perhaps private equity firms as your company grew and matured. And typically, historically, after five years or so, if you had a successful company, you would then go public.

That’s changed. Today, the typical private company prior to going public actually remains private for about 12 years. So we’ve seen a more than doubling of the amount of time that private companies are choosing to remain private. So what that means is this supply chain of new companies that feeds public markets, it’s really slowed down.

It’s not because there’s a lack of entrepreneurialism in the United States. Absolutely not. We still see plenty of private investment opportunities in the United States and certainly the world over. What we’re just observing, Josh, is that fewer and fewer companies are choosing to go public. And those that do are choosing to stay private for longer prior to going public.

And so the other side of that coin is if you’re only investing in public markets, I guess you’re not participating in those companies as early in their growth cycle.

That is absolutely correct. And so if you think about what that means, if you’re investing only in public markets, and I want to be very clear with our audience, there’s nothing wrong with investing only in public markets. What we’re talking about is building optimal portfolios. How do we maximize the level of diversification in a portfolio? And how do we maximize returns for a portfolio?

For a lot of different reasons that we can discuss, private companies generally tend to deliver much higher returns to investors than their counterparts in public markets. And so for those reasons, typically allocating a portfolio to private investments is going to result not just in broader diversification, but also higher return opportunities for the portfolio as a whole.

Well, a lot of people have heard of talking about asset allocation is you’ve got 60% stocks, 40% bonds. And I guess what you’re talking about, it’s not going to taking that public markets out and doing only private markets, just talking about maybe you’re at 40% public markets, 30% private markets, 30% bonds is a new way to think about that top level allocation.

Yeah, correct, Josh. That’s one way of thinking about it. Whether it’s 10%, or 20%, or 30%, that’s ultimately a financial planning question that investors need to determine in working in close partnership with their advisors, and their CPAs, and things like that.

But correct. We’re not talking about an all or nothing. In fact, the whole premise of diversification is that you should resist this all or nothing way of thinking about your investment portfolio, and that you should embrace more of a buffet style approach to how you think about your portfolio. By owning lots of companies, lots of asset classes in lots of different markets, that’s really the best way to earn the highest returns possible with the lowest amount of portfolio risk.

Now, what kind of opportunities are there in private markets? You mentioned earlier that there’s 10 companies that make up over a third of the S&P 500. Is it the case that all your really large companies are in publicly traded stocks? And when you go into private markets, you’re looking at smaller type of companies? Or what’s the landscape like for private market investments?

This is one of the most startling statistics that I think is just so interesting. A few moments ago, Josh, we were explaining that there’s about 3,500 publicly traded stocks in the United States. If we actually look at the private markets, the opportunity set that is available to investors is dramatically higher than what’s available in public markets.

By most estimates, there are five times as many private companies in the United States with revenues over $100 million annually. So we’re talking big companies, Josh. We’re not talking small mom and pop pizza shops. We’re talking companies with $100 million or more in revenue, annual revenue.

In the United States alone, there are five times as many investment opportunities that meet that requirement than there are publicly traded companies. In fact, when we look globally, there’s about 140,000 private companies that have annual revenues in excess of $100 million per year. That is dramatic. It is an order of magnitude larger than what is available in public markets.

Now, this is obviously a huge topic. And there’s a lot of questions that we’re not going to get into in this podcast introducing it. And I think we’re going to have future podcasts where we talk about some of these things of how do you actually build a portfolio in private markets. There’s a lot of considerations for how you would do this.

But before we wrap up here today, we should probably talk a little bit about what the risks are like in private markets. How do they compare to public markets? What are the considerations an investor ought to have at a high level if they’re thinking about going into this? Don is a fiduciary. What’s the cautionary advice that you would want to remind people about?

Josh, that’s a great question. It’s a great point. Those higher expected returns that we observe in private markets, they are not risk-free. And I think that is a critically important point to drive home to our listeners. These are private companies. When you invest in private companies, for example, if you’re investing in a private equity fund that is investing in private companies, these are very long-term investments.

You’re going to be in these funds for anywhere from 10 to 15 years, sometimes even longer, depending on the fund’s unique circumstances and what they are investing in. By definition, these are illiquid investments. These are very different from going into your Schwab account or your Fidelity account and clicking the Sell button.

You can’t do that with private investments. So these are fundamentally illiquid. And I think that’s one of the biggest risks that investors need to really understand that these are fundamentally illiquid. That’s number one.

Number two, because they’re private. Getting access to information on these investments is more challenging. It’s not impossible, but it’s certainly more challenging. These are private companies. They don’t typically have any auditing requirements. They’re not required to publish audited financials like public companies do.

So getting access to information is going to be certainly a bit more challenging. Now, the fund managers that run these private investments, you can bet that they certainly are getting audited financial information that they need from the companies that are trying to raise capital. But as end investors, typically, it’s harder for us to get access to all of that information on our own.

I think the last point that I would make here, perhaps two more points, Josh, is that typically, the fees are a lot higher when you are investing in private market investments. Typically, you’re paying an annual asset management fee of about 2% per year, plus what’s called an incentive fee. That’s typically could be as high as 20% of all the profits would go to the fund manager, who we actually refer to often as the GP, the General Partner.

So the fees are certainly higher, there’s less transparency, and they’re illiquid.

All of those are the costs that we, as investors, have to incur in pursuit of those higher expected returns that I mentioned earlier at the start of our podcast. If you’re looking to outperform public markets and diversify beyond public markets, well, that certainly comes at a cost. And those are just some of the costs.

And I think, Josh, the last point I would just make is that the Securities and Exchange Commission does have very strict regulatory requirements that govern what types of investors are permitted to invest in private investments. And so depending on your investable assets, depending on your net worth, depending on your income, that will often govern what private investment opportunities are available to you.

So there’s obviously a lot more to say about this topic, but we’re going to have to save a lot of these conversations for future podcasts. It’s going to be fun to delve into this some more. But for now, thanks for joining us. Special thanks to Don Calcagni for his insights.

If you’re already a Mercer advisors client, feel free to reach out to your advisor with any questions about the role of private markets in your portfolio. And if you’re not a client but would like to learn more, the first step is just arranging a phone call, have our team call you, or visit our website, merceradvisors.com. Until next time. This is Market Perspectives.

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