Rethinking private markets - From IMAP Independent Thought

By IMAP Team

While private equity can provide investors with capital gain and growth, and private debt with stability of capital and an uncorrelated source of income, private market assets don’t come without their risks. Adrian Mackenzie (Five V Capital), Andrew Lockhart (Metrics Credit Partners), Jonathan Ramsay (InvestSense), and Kyle Lidbury CFA (Perpetual Private) discuss the role of private markets in retail portfolios.

It might come as a surprise to advisers but as a broad asset class, alternatives are growing steadily. You only need look at Australian private capital which, in line with global trends, has grown at a CAGR of 12.1 per cent since 2010.

Speaking at the IMAP Independent Thought Conference in Sydney, Adrian Mackenzie - Partner at Five V Capital - was quick to point out that private equity and venture capital continue to represent the largest share of AUM for alternatives. It’s not surprising, therefore, that this is a sector of the market that Adrian believes provides advisers and portfolio managers with many opportunities.

“Australian private capital reached a record of $90 billion at June 2021, with low interest rates and slowing global growth driving greater focus on alternatives to bolster risk-adjusted returns,” says Adrian. “Private equity and venture capital collectively represent the largest private capital asset class in Australia, with a record amount of over $42 billion in AUM as at June 2021.”

However, he acknowledges that the take-up of private equity and venture capital in Australia has been relatively slow to date compared to the U.S., even though private equity has historically outperformed public equities throughout various market environments, consistently delivering strong returns across cycles.

According to Adrian, in order to achieve capital gain and growth, manager selection is crucial in private equity, with the spread between top and bottom quartile funds being 12.9 per cent, compared to just 1.5 per cent for public equity funds.

On the flip side of private equity, which is focused on capital gain and growth, is private debt. Individuals invest in debt to gain the benefit of stability and protection of capital, and also to generate an attractive source of income. 

For the Managing Partner at Metrics Credit Partners, Andrew Lockhart, private debt is an asset class that delivers stability of investor capital and an attractive, uncorrelated source of income. It does this in five ways:

• As a private market, income is less exposed to public market volatility;
• Portfolios are typically diversified across industries, sectors and credit quality;
• Regular income is received from floating rate interest payments of borrowers;
• Borrower diversification increases the stability of returns and reduces concentration risk; and
• Loans are short-dated, secured financial contracts, which enhances return stability.

However, he cautions that the biggest risk to an investor is credit loss in the event of a default.

“This asset class has become increasingly available to investors. It’s a very wide and broad market. At one end of the spectrum, you can provide investors with exposure to senior unsecured investment grade credit that would be equivalent to a traditional bond. At the other end of the risk spectrum, you can provide investors with exposure to high yielding debt through mezzanine or subordinated debt,” says Andrew.

He believes what makes private debt so attractive is the ability of investors to provide funding where capital is scarce, enabling them to take advantage of market inefficiencies.

“For example, over the past 5-7 years, the banks have largely withdrawn from the financing of commercial real estate related activities, as they have deployed more of their capital to the retail home loan side. As a result of that, access to capital has been restricted,” says Andrew.

“However, the returns that have been delivered to investors by directly lending to these commercial real estate related activities has been quite attractive. In our own funds, we are now yielding close on 9 per cent for first registered mortgage short-dated secure property loans. On a risk-adjusted basis, that’s a very attractive position.”  

But why should advisers be interested in private markets, which have traditionally been the domain of institutional investors?

Adrian says there is an enormous push by private equity houses globally, like Blackstone and KKR, to tap into high-net-worth retail investors. These firms recognise the significant amount of capital that sits outside the institutional platforms.

It’s a developing trend that Kyle Lidbury CFA - Head of Investment Research at Perpetual Private - recognises. When considering whether alternatives should be part of the asset mix of an investor’s portfolio, he believes it is important to think about the fundament principles of what advisers are trying to achieve for their clients.

“Advisers are planning to provide clients with a given outcome, and the more certainty they can have on that future outcome, the better,” says Kyle. “The reason we are using alternatives is to build a more resilient portfolio that will increase the certainty of delivering clients with their given outcome.”

He points to the decline in the number of publicly listed companies, while growth in the private and unlisted asset sector continues. Kyle believes this growth makes private markets an increasingly larger part of the investible universe for investors.

“As higher inflation and market volatility continues, we’re going to have more risk and drawdowns, and less certainty on outcomes. So, we need to access other asset classes that are not traditionally tied to market beta, equities and bonds, in order to get more certainty around the investment return. That’s why we are investing in private markets.”

However, Kyle does acknowledge the risk that comes with private debt, which is capital loss through defaults.

“You need to consider that these are unrated borrowers. You’re effectively earning a higher interest rate because of that risk,” says Kyle. “However, we haven’t really seen a default cycle in private debt in Australia, yet. And while there are structural protections in place by the Government to assist banks, it’s unlikely it will bail out private debt providers as well.”

As a private lender, Metrics Credit Partners is not regulated, which means it is not required to hold regulatory capital against its assets, which Andrew views as being an advantage.

“Because of the regulatory capital that is required to be held against a bank’s assets, if their credit quality deteriorates, they tend to become forced sellers,” he says. “Whereas our interest is to protect our investor capital through the cycle. A lender with the skillset that understands how to structure appropriate terms and conditions, and to manage risk, I believe is well positioned to protect and preserve investor capital.”

When evaluating private markets, Kyle says it’s important to consider liquidity issues, as investors will generally be investing in structures that have lock-up periods for their capital.

“Investing in private markets means you’re investing in structures that have, for example, 10-year lock-ups. But retail investors need liquidity,” says Kyle. “The whole point of managed accounts is to run a portfolio that you can apply across your client base. However, by running closed-end structures, you’re not going to be able to do that within a managed accounts structure.”

It’s a view supported by Jonathan Ramsay - Director at InvestSense - who essentially doesn’t believe private market assets are suitable for a managed accounts structure, unless it’s a bespoke SMA.

“The reality is, the liquidity issue of private market assets make them unsuitable for managed accounts, so advisers need to manage this carefully,” says Jonathan.

However, he believes there are other alternative structures that advisers could consider that address the liquidity issue with private credit and debt. He refers to creating something along the lines of an industry fund for clients.

Jonathan explains: “You can get the same risk profile. Advisers just need to explain to their clients that there is a percentage of the portfolio, say 30 per cent, doing what industry funds do, and there is a percentage, say 70 per cent, which is the liquid part of the portfolio. Although that approach is not seamless, you don’t often have to write ROAs. It might be a suitable alternative structure for retail clients wanting exposure to private market assets.”

Kyle agrees, saying solutions like this are all about evolution in the space. “We’ve seen it in infrastructure and real estate, where you can run a vehicle that has listed and unlisted exposures to provide liquidity. As more providers come to market, you’ll get more client-friendly structures.”

However, Andrew disagrees that there are liquidity issues with all private debt offerings. He cites Metrics’ offering, which provides a range of ways investors can gain access to liquidity. According to Andrew, Metrics’ offering doesn’t have a five or 10-year lock-up. Instead, the average loan in its real estate debt fund is less than one-year. Investors in that fund are generating close to 9 per cent net of fees and costs, with a liquidity profile that matures every 12 months.

“We’ve got listed and unlisted funds. We have designed funds specifically to cater for investor requirements in terms of: their return objective; the risk they are willing to take to achieve that return; and the ways they can gain liquidity,” he says.

However, Andrew does accept that not all debt is liquid. In fact, there are positions in Metrics’ funds where it takes profit shares, options, or where it holds equity positions.

“And while we do have specific processes to deal with less liquid assets in our portfolio, it’s important that people are not allocating money to a traditional bond fund simply to lose money because they’ve got liquidity issues. Return and risk management are the two key factors investors should be thinking about with private debt.”

Finally, when it comes to investing in private markets, Andrew emphasises that advisers and investors need to do their due diligence and research to fully understand: the governance structure around the investment; the skillset and competency of the people managing the money; and how the manager is committed to delivering on the returns to investors.

“If you get that right, you can be confident that private equity can provide you with capital gain and growth, with private debt providing you with stability of capital and an attractive, uncorrelated source of income,” says Andrew. “It’s definitely an asset class worth considering.”

Andrew Lockhart is Managing Partner at Metrics Credit Partners;

Adrian Mackenzie is a Partner at Five V Capital;

Jonathan Ramsay is a Director at InvestSense; and

Kyle Lidbury CFA is Head of Investment Research at Perpetual Private.

They spoke on ‘The role of alternatives and private markets in portfolio management’ at the IMAP Independent Thought Conference - Sydney.

The session was moderated by David McDonald CFA - Investment Specialist at IMAP.