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The vast majority of individual investors are familiar with one market — a liquid and public one where companies are well researched, prices quickly reflect new data, almost everyone sees the same information, and news spreads in seconds. This is the market for public equities and the related market of publicly traded debt securities, which continue to dominate individual investor portfolios and business headlines.
But beneath the continuously updated stream of public company news, the investable universe being covered is shrinking at a steady pace. Over the past 20 years, the number of publicly listed U.S. companies has nearly dropped in half, from 8,090 in 1996 to around 4,397 in 2018, while the average age has increased from 12.4 years old to almost 20 years.¹
The implications of this trend are profound. Companies that remain public are older and more mature, on average, than listed firms in years past. Companies are staying private longer and, by the time they IPO (if they do at all), most of their growth and value creation is often behind them, reaped by a relatively small number of private investors.2,3
One might conclude that venture capital and private equity firms today are extracting most of the value out of their portfolio companies before considering taking them public and that the best small companies looking for growth capital and/or liquidity are increasingly opting to tap the private capital markets or sell to strategic acquirers rather than go public. Moreover, the majority of the stocks that have disappeared from the public markets are small cap, which have historically generated higher levels of growth than their large cap peers.4
Private Equity Projected to Continue to Outperform Public Markets
The fact is that much of the economic growth today is taking place outside of the public markets, beyond the reach of most individual investors. What’s more, with valuations near all-time highs and the bull run in U.S. equities more than 10 years old, many asset managers are now forecasting 4%-6% nominal returns over the next 10 years from a conventional 60/40 portfolio, rather than the 8%-9% such an approach yielded in past decades.5
To achieve an 8% return going forward, qualified investors should have some exposure to the private marketplace, which offers diversification and the longer-term fundamental growth opportunities that used to be available in the public markets (Figure 1).
Figure 1: Private Equity Returns vs Public Markets
For illustrative purposes only. Source: Cambridge Associates, US Private Equity Index and Selected Benchmark Statistics, Q4 2018. Past performance is not indicative of future results.
Breaking Down the Private Market
So, what does this private market look like? In terms of number of companies, it is massive relative to the public markets (Figure 2). Here are some basic facts:
- There are 7 million private U.S. companies.6
- The top 225 private companies alone have combined revenues of $1.6 trillion and employ 4.8 million people.7
- There are nearly 200,000 U.S. middle market businesses, over 98% of which are private, and they represent one-third of private sector GDP and employ approximately 48 million people.8
- Earnings at private, middle market companies increased 8.5% in Q2 2019 from a year earlier, representing continued strong annual growth.9
Figure 2: Largest 185,000 Companies in the U.S.
For illustrative purposes only. Source: NAICS Association, Firmographic Breakdown of Business Establishments by Company Size.
Despite the relative attractiveness of private markets and the need for additional sources of portfolio returns, a recent survey of the global private wealth management industry found individual investors have dismally low private market allocations – less than 1%.10 This is far below the levels commonly held by the highest-performing institutional investors, a growing number of which are now 40% invested in private markets.11 Top-quartile endowments have at least 15% of their portfolios invested in the private markets, according to Cambridge Associates.12
Barriers to Investing in Private Markets Are Falling
The two main obstacles that have historically held investors back from accessing the private markets are the lack of liquidity and the lack of access to high-quality fund managers.
While concerns about the illiquid nature of private equity have kept many qualified individual investors from committing to the asset class, the longer-term horizon is something they should be embracing. After all, thinking and acting long term is what enables private equity firms and their portfolio companies to create significant value. They pursue strategic initiatives that require several years to execute, and they don’t have to worry about quarterly earnings calls and the resulting short-termism that afflicts so many public companies. Thus, an inherent benefit of committing capital to a private equity fund is that it essentially forces the investor to adopt a buy-and-hold discipline and places the exit decision in the hands of experienced professionals who are closest to the assets.
Further, investors tend to overestimate the amount of liquidity that they need in general. According to a recent BlackRock study, institutional investors with high spending rates – as high as 8% of the portfolio – can sustainably manage allocations up to 20% in private investments. Advisors and clients following the “4% Rule” – which is generally regarded as a conservative spending rate – could manage a meaningful allocation to the private capital markets.13
Private equity has been the domain of institutional investors due in large part to high investment minimums and the fact that fund managers lack the infrastructure to service small investors at scale. That’s beginning to change, thanks to technology. Today, well-established, top-quartile fund managers are entering the high-net-worth market, drawn by the creation of feeder funds that efficiently aggregate smaller investments and streamline the subscription and account servicing processes. As a result, a growing number of advisors and their clients are accessing funds at investment minimums as low as $100,000 versus the $5 million to $10 million these funds have historically required.
As more advisors and investors become aware of the potential benefits of private equity, we anticipate that it will evolve into a core portfolio holding for a broader audience of investors who understand the advantages of longer-term investing and want to diversify their portfolios.
Nick Veronis, Co-Founder & Managing Partner, iCapital Network
1Source: The World Bank, accessed September 2019.
2 Source: Jay Ritter, University of Florida, “Founding dates for firms going public in the U.S. during 1975-2018,” accessed May 2019.
3 Sources: Equiam, S-1 and other regulatory filings, Yahoo Finance, as of April 2019.
4 As of March 31, 2019, the Dow Jones US Small Cap Index has outperformed the S&P 500 over the prior 20-year period, returning 9.87% annually vs. 6.04%. Source: Cambridge Associates.
6 Source: Kaiser Family Foundation, “Number of Private Sector Firms, by Size,” 2018.
7 Source: Forbes, “Americas Largest Private Companies,” October 22, 2018.
8 Source: The National Center for the Middle Market: Q2 2019 Middle Market Indicator.
9 Source: The National Center for the Middle Market: Q2 2019 Middle Market Indicator.
10 Source: iCapital Network Research, 2019.
11 Source: Cambridge Associates, “Private Investing for Private Investors,” July 2016.
12 Source: Cambridge Associates, “The 15 Percent Frontier,” July 2016.
13 Source: BlackRock Investment Institute, “The core role of private markets in modern portfolios,” March 2019.
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