How can investors navigate the private assets investment landscape? This brief overview – the first in a three-part series drawn from a recent paper – explains the main concepts, definitions and terms.
We highlight the benefits of investing in private assets such as reduced risk through diversification, enhanced returns via an illiquidity premium, and less exposure to short-term public market volatility. We also discuss some of the risks and challenges to be taken into account. Private assets in 2022 were estimated to have about USD 7.6 trillion and USD 1.3 trillion in assets under management, respectively and are expected to play an increasingly important role in sustainability-related investing.
Opening a more accessible window to private asset investing
The minimum investment in a private assets fund is often relatively high. For private equity and private debt, it typically starts at EUR 200 000 and EUR 100 000, respectively, but it can reach tens of millions of euros. Such steep thresholds have made the segment the preserve of institutional investors.
However, that may change soon, especially in Europe. The revised European Long-Term Investment Funds Regulation (ELTIF regulation 2.0), which will apply from 10 January 2024, allows for the creation and distribution of funds that include an allocation to private assets.
One innovation under ELTIF 2.0 is that it distinguishes between long-term investment funds that target professional investors only and ELTIFs that target retail investors, removing both the EUR 10 000 minimum investment requirement and the 10% cap on financial instrument portfolios not exceeding EUR 500 000 for retail investors.
A growing number of open-ended funds allocate in part to private assets to help boost returns and reduce volatility. These are available to retail investors, enabling them to access diversified portfolios of private assets that might otherwise be out of reach. We explore allocating to private assets in open-ended funds more fully in the second article in this series.
Care, patience and diligence required
Investing in private assets can be complex. Private assets are not publicly traded, which means they are less liquid and require a longer-term investment horizon. Private asset investments often involve higher fees and require more due diligence than traditional investments.
Those seeking to invest in private assets, either directly or through private asset funds, need a clear understanding of the different types of private assets and how they generate returns. They should also be familiar with risks such as illiquidity risk, concentration risk and operational risk.
The fundamentals
In private equity, capital is used
- To invest in or buy companies that are not listed on a public stock exchange
- To engage in buyouts of public companies.
Private equity involves active ownership: capital is invested in exchange for an equity stake or (part) ownership. Investors thus have influence or control over a company’s operations as they seek to increase the value of the company over time before eventually selling it at a profit.
Public equity investments can be traded daily, but private equity assets are illiquid, which explains why investors may expect an illiquidity premium.
In Private debt, capital raised from investors is lent directly to both listed and unlisted companies. It is also used to finance real assets such as infrastructure and property or ongoing business operations.
Private debt funds provide investors with exposure to returns that are more bond-like. Private debt deals involve fewer lenders and borrowers work more closely with lenders. The cost for the borrower is usually lower because fewer lenders are involved and the process of working out a debt (re-)structure in the event of a default tends to be faster. Put together, such factors contribute to higher recovery rates for private debt on average than those on more common syndicated loans.
The key risk is illiquidity, so private debt comprises potentially higher yielding opportunities for investors. Private debt funds are also typically less diversified (by number of positions).
Private debt managers tend to raise new capital during fundraising periods. Much as with private equity, the committed capital is not put to work immediately. Instead, it is called and then invested over a number of years as suitable investment opportunities arise.
Private debt loans typically carry floating rates, offering investors some protection against inflation eroding returns. This contrasts with fixed-rate bonds: they lose value when inflation or interest rates rise.
Private debt can be issued with different levels of seniority. A senior loan is repaid first should the borrower default. After that, subordinated, or junior, loans are repaid in the event of bankruptcy.
Mezzanine debt is senior only to equity, contains embedded equity options, is usually issued with rights to convert to equity in the case of default, and is unsecured. It demands relatively high interest rates.
Private assets – A growing force in sustainable finance
There are an increasing number of opportunities to invest in private assets with a sustainable impact.
Also growing in importance is the role private assets can play in impact investing, e.g., funding projects with a positive net environmental impact.
Private equity is particularly well suited to impact investing. Its longer investment horizons mean it is suited to achieving a positive social and environmental goal as investors exert a strong influence on investee companies and can more easily access the data needed to steer a company and its activities.
Private debt also works well for impact investing, as it has a similarly long investment horizon. Investors can use private debt to:
- Fund infrastructure and community development projects
- Provide working capital for grassroots impact organisations
- Fund microfinance institutions that cater to underbanked communities
- Merge numerous impact-focused assets and structure them as senior or subordinated loans.
More allocations to come
Large institutional asset owners are likely to double their allocation to private assets in the next four years. This could mean shifting hundreds of billions of euros in capital annually towards private assets, in particular infrastructure, accelerating investment flows.
G20 governments are relying increasingly on private investments for infrastructure building and repair. Examples include the adoption of the European Union’s ‘Fit for 55’ legal proposals and the passage in the US of the ‘Infrastructure Investment and Jobs Act’.
Such moves encourage and facilitate significant investment in renewable energy and clean technology, digital infrastructure, artificial intelligence and biotechnology, hospital and other social infrastructure, waste management, and transport infrastructure.
Private equity firms are increasingly taking environmental, social, and governance factors into account in their investments as they see the positive correlation between managing such factors effectively and companies’ profitability and market values. Successfully managing ESG risks and opportunities as part of the investment and value creation strategy can improve returns while reducing vulnerability to risk.
Corporate customers are demanding a more positive social impact, employees want to work for purpose-driven organisations, and a growing number of investors prefer to fund companies whose models and aims are ESG-aligned. Such factors are likely to gain in importance in private equity firms’ decision-making.
Disclaimer
Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
Environmental, social and governance (ESG) investment risk: The lack of common or harmonised definitions and labels integrating ESG and sustainability criteria at EU level may result in different approaches by managers when setting ESG objectives. This also means that it may be difficult to compare strategies integrating ESG and sustainability criteria to the extent that the selection and weightings applied to select investments may be based on metrics that may share the same name but have different underlying meanings. In evaluating a security based on the ESG and sustainability criteria, the Investment Manager may also use data sources provided by external ESG research providers. Given the evolving nature of ESG, these data sources may for the time being be incomplete, inaccurate or unavailable. Applying responsible business conduct standards in the investment process may lead to the exclusion of securities of certain issuers. Consequently, (the Sub-Fund’s) performance may at times be better or worse than the performance of relatable funds that do not apply such standards.
