Enter the world of private capital markets
by Amro Abdulla Al Qubaisi
A group of swindler’s and twits, replied a family office investor as we sip our coffee at La Galerie — Champs Elysees, Paris on10th of July 2016 and before heading to the stadium to watch the Euro championship final match between France and Portugal.
This was unfortunately the reputation of private market sponsors and fund managers amid a rise in the number of zombie funds and increasing amount of dry powder. The view is still true today and allot of investors in the MENA region hesitate to invest in private market offerings due to- previous losses arising from lack of knowledge about private capital markets investment models and asset allocation strategies, absence of manager selection and due diligence process, bad governance and misalignment of interests.
My roads with private capital markets crossed on multiple occasions through out my career as lead manager, custodian, arranger, placement agent and advisor. However, in 2021, I decided to take a deep dive into the world of private capital markets and found that Investors often invest in private asset classes to boost the return profile of their portfolios. Yet, many fall short of achieving the desired returns.
Furthermore, the historical data I reviewed reveals a large return dispersion between top- and bottom-quartile fund managers and top- and bottom-quartile institutional private market portfolios, revealing the challenges that investors face when building a private markets program.
In this article, I provide a general overview of private capital markets, debunk some myths about private market investing, highlight the key considerations for any investor seeking to build a private markets portfolio: (i) investment and asset allocation models (ii) manager selection, (iii) investment & commitment (iv) portfolio diversification, and (vi) j-curve impact management.
Based on data and reports by Preqin, McKinsey’s Private Markets Annual Review, and Private Equity International — by 2026, private markets AUM is estimated to reach $11.12 tn at a YoY growth rate of 19%+.
The size of the private equity market has tripled in the last decade, from nearly US$2 tn in 2010 to over US$6 tn in November 2021.
Secondaries and private debt is among the fastest growing strategies. Annualized estimates from October 2021 put private debt assets under management (AUM) near $1.21tn for year end. This is off the back of a decade of growth, which averaged 13.5% annually, ahead of both private equity & venture capital (11.5%) and real estate (9.1%). Global secondaries reached $280bn in 2020 at a 7 year CAGR of 53% (2003–2020).
Private infrastructure will reach $1.87tn by 2026, overtaking real estate to become the largest real asset class. Real Estate AUM expected to reach $1.8tn by 2026.
Additional Key Figures
- Total funding in 2021 reached $788bn between 1385 funds, with an average fund size of $530mn.
- There are 6365 Institutional investors investing in private equity markets, a 64% increase since 2017.
- $410bn worth of venture capital backed exits in the first Q3 of 2021.
- 708 Private debt backed deals in 2021
Private Capital Markets
On daily basis we interact directly or indirectly with this world. Yet, the average person is unlikely to notice. For example, buying services and products from private companies that are backed by investors (i.e Venture Capital Funds and Limited Partners). Or getting access to assets, commodities and natural resources made available by operators backed by private investors. More specific examples include:
- Ordering your grocery through a venture backed start-up app, booking holiday home on Airbnb, or posting on Instagram.
- Driving your car on the highway, or charging your electronic vehicle.
Private capital markets typically refer to private investments through funds and investment vehicle structures. These vehicles invest in assets not available on public markets. Main asset classes include private equity, venture capital, private debt, real estate, infrastructure, and natural resources.
Interests in these assets or groups of assets are typically arranged as limited partnerships with investors referred to as LPs. General Partners, or GPs, act as the investment manager, calling and deploying capital from the LPs.
It is worth noting that the world of private markets consist of various industries, distinguishable from each other by characteristics such as the asset type that is bought, managed, and sold, the development stage of the asset, and the investors’ risk–return preference.
Lets now look at the private market major subsets or asset classes in more detail:
1- Private Equity: Includes all equity investments that are not publicly traded, and is divided into informal and institutional PE. Institutional PE can be further divided into venture capital (VC), growth capital, and Leveraged Buy Outs (LBOs), based on the development stage of the company in question. Other forms of PE investing which is gaining more popularity recently include management buyouts, turnarounds, and secondaries.
A different classification system is used for real assets than is used for corporate PE. Transactions are classified as a function of how passive (as opposed to active) the investment strategy is:
- Core: An investment in a pharmacy with a 30-year lease is core. The pharmacy requires minimal maintenance and generates a stable revenue stream.
- Core plus: These refer to less stable assets and strategies, despite what the name suggests.
- Value-add: The next step up in activeness is value-add. For example, you buy a property with a high vacancy rate at a discount and initiate physical and operational improvements to increase occupancy. Once the property is fully occupied, you may sell it to a core fund. A value-add strategy is associated with minimal business-cycle risk, requires a value-add plan, and uses more debt than core (50% debt financing compared to 25% for core).
- Opportunistic: This is basically an LBO and entails more entrepreneurship, assets held for a shorter period, and more debt (up to 70%).
3- Private Debt: Private debt (or direct lending) can be understood as a fund backed by investors providing debt financing to privately held companies. Private debt transactions or investing can be in the form of direct, mezzanine, distressed, special situations and venture debt. More recently, new debt structures have emerged offering solutions to GPs and LPs. For example, LP commitment financing, fund restructuring and liquidity solutions.
Other subsets include private arts and collectibles, and private digital assets. These new subsets are gaining momentum and are becoming more and more part of the institutional investor portfolio.
Private markets are run by a range of participants, each with unique roles and responsibilities. The deal process can take 6–12 months, costly, and decisions rely heavily on set of skills currently in scarcity.
Private capital markets are characterised by high access barriers, illiquidity, long investment periods, and obscurity of information. However, with high return profiles, provides portfolio diversification and risk optimization.
The outperformance of private equity compared to public equities is widely publicized, with data from a range of providers showing that the former has outperformed the latter, often significantly. JPMorgan Asset Management, for one, estimates that in the 15 years through the end of 2017 private equity generated a 14.4 percent net annual return versus 8.8 percent for the MSCI World equity index.
Yet, many investors has a negative or to be more accurate an incorrect view of private capital markets.
Myth #1: Private Equity is risky
Less appreciated than private equity’s outperformance is its lack of downside risk. Research from Hamilton Lane and JPMorgan Asset Management shows that two-fifths of publicly-listed equities experience “catastrophic loss,” defined as a 70 percent or greater drop from peak value, with minimal recovery. Yet less than 3 out of 100 private equity funds suffer similar loss. In this regard, stocks are a stunning 13 times riskier than private equity funds.
A 47-page study builds on this idea that private equity is less risky than many assume. In the study, “Private Equity and Financial Fragility During the Crisis” compares the performance of nearly 500 private equity-backed companies in the United Kingdom with non-PE-backed peers of similar size, purpose and profitability.
The study’s authors — from Harvard, Stanford and Northwestern — found that on average PE-backed companies recovered faster from the Global Financial Crises, and ultimately captured more market share in their respective sectors, than their non-PE backed rivals. They also determined that despite significant amounts of leverage, PE-backed firms were no more likely to go bankrupt than their peers. The long-term horizon of private equity funds, the traditionally activist approach of PE owners, and their access to cash through uncommitted capital and credit networks — including banks and private funds — permitted PE-backed companies to issue more debt and equity than peers, making them more resilient and, finally, faster growing.
Myth #2: Private Equity = private capital markets
The private capital market investment spectrum has a wide range of asset classes and strategies. However, investors associate private capital markets with private equity as it outperformed other asset classes, and as it captured majority of private market fundraising.
According to McKinsey Global Private Markets Review 2022 — Private equity drove global growth in private markets where AUM reached a new high of $6.3 trillion, driven primarily by asset appreciation within portfolios. PE also continues to outperform relative to most public market equivalent (PME) measures.
Myth #3: Big funds managed by household GP names are best performers
Based on my research and after performing some financial modelling, single asset managers and smaller funds tend to out perform larger funds. This is due to lower costs associated with setting up and managing a fund, and efficiencies' resulting from developing sector specialism.
This view is further supplemented by the outperformance of funds investing in small to medium cap companies. In 2014, private equity funds-of-funds leader Adams Street Partners analyzed some 1,600 realized investments made by funds it owned. It discovered that funds investing in small and mid-cap companies achieved a return of 2.5 to 2.6 times the amount invested. Larger manager returns are respectable, but less consequential 2.0 times the amount invested. Adams Street also found that small companies tend to have less debt and lower purchase prices (measured as a multiple of cash flow), making them even more bulletproof in downturns than larger companies.
Private Equity International reports that Adams Street’s allocation to small and mid-cap funds has increased to 75 percent from some 50 percent since the study concluded, and the firm’s executives say they continue to load up on small companies — specifically to prepare for the next recession.
Myth #4: IRR is a reliable performance measure
IRR can’t be used as a performance metric, and at best a comparison metric. However, the reliability of IRR as a performance measure is put into question as change in NAV or distribution amounts do not alter IRR.
Alternative measures such as money multiples and PME can provide better insight into fund performance. PME informs LPs about a fund’s performance in relation to a benchmark. Any benchmark can be used, but a benchmark that reflects the nature of a fund’s underlying assets will provide a better measure of investment performance. Finally, Modified IRR can be another metric to use when measuring performance.
Aligning your selected investment strategy with your investment model is crucial to successfully build wealth. In other words, selecting the right private capital market strategies will depend on your objective, return and risk profile.
In private market investments, there are two popular investment models: The Endowment model and the Canadian model. These investment models have marked differences, they are both characterised by an investment portfolio that allocates more investments to private markets than traditional institutional investors do.
The Yale Endowment Model: The Yale Endowment is top-down, which means that the investment team first decides in which asset classes (e.g. VC, LBO, and real estate) they want to invest and how much they will invest in each one, before proceeding to make any investments. Within the identified asset classes, they then look for specific investments and deploy the predetermined amount.
In contrast, a bottom-up approach does not have a predetermined objective in terms of asset classes within equity, such as public equity, LBO, or VC. Instead, it starts with a broader set of asset types identified as viable for the endowment and then locates investment opportunities within those types. For example, a target amount will be allocated to equity as a whole, and managers may invest in whichever opportunity seems suitable.
University endowments in the UK tend to be smaller than those in the US, with Oxford and Cambridge each managing assets of about $US8 billion. Cambridge and Oxford allocations are similar to those of Yale but are less heavily invested in hedge funds and private markets, and more heavily invested in public equity.
The Canadian Model: An important feature of the Canadian model is its bottom-up approach to investing and the use of an opportunity cost model. Instead of deciding how much to invest in each asset class (like the Yale model), the Canadian model decides only on allocation to debt, equity, and real assets. All the capital is allocated to the market portfolio within each of the three asset classes, also known as a reference portfolio. The reference portfolio simply invests in all the publicly traded assets that are investible in proportion to their size.
Each team sourcing an opportunity needs to demonstrate that it is superior to the most closely related holding in the reference portfolio. For example, assume you are presented with an opportunity to invest equity in a Swedish VC-held company called Skype in 2009. If you decide to make this investment, you finance it by selling a number of publicly listed tech companies located in Europe. You then track whether you did better by investing in Skype versus having kept the public tech stocks in the portfolio, and you are financially rewarded accordingly.
The Strategic Asset Allocation (SAA) approach, the most common asset allocation approach, is based on modern portfolio theory (MPT) and uses mean variance optimisation (MVO) to produce target portfolio allocations. MVO attempts to either minimise risks for a given target return or maximise returns for a given target risk level. More sophisticated optimisations can:
- Seek to minimise the risks associated with not achieving a specific investor goal; and
- Allow for the uncertainties associated with forecasts of risk and return of different asset classes (i.e. you may be more confident in some assumptions than in others).
However, sophisticated optimisation calculations can create complexity and provides room for error. Investing in computational technology or hiring professional and experienced advisors is a must.
Building a portfolio of top-quartile managers requires sourcing capabilities, experience in due diligence, and good judgement. Sourcing good GPs is a labor-intensive process of proactively establishing relationships with managers, marketing firms/placement agents, and other LPs.
Due diligence often takes 2–3 months of work on each fund and requires an understanding of how a strategy has generated value in prior investments and how repeatable that performance might be in the current market environment. With this in mind, I would recommend investors to appoint investment advisors with the needed skill sets and resources to focus on:
- Identifying high potential, repeatable skill; and understanding the key risks, both those that are mitigated and others that may not be in consideration of long-term illiquid fund commitment.
- Active management premium defined by the ability to buy businesses at an attractive value, provide growth capital and/or participate in the creation of early stage companies, and operate companies more efficiently by adopting incentives that better align both the operating and investment managers all contribute to what I believe are an active management premium.
- Capital resource optimization (human, financial and technology). So investors need to look into the team backgrounds, skills, and experience. Employee attrition and retention rates, renumeration and employment policies are equally important. Access to funding, cost structure, and accounting methods must be understood. How they utilize technology in the sourcing, valuation, and fund administration are good indication of efficiency.
- Governance is something that I personally tend to focus on. A board composed of VIPs and a complicated web of committees is not necessarily an indication of good governance. Good governance is determined by three things: diversity and independence of the board and committees, quick decision making & frequency of board / committee meetings, and effectiveness of the board and committees. Investors and advisors will need to dig deeper into things like board / committee renumeration policy, appointment policies and procedures, roles and responsibilities, what is included in a board pack, cost structure, NAV and accounting policies.
- Alignment of interests. Too often I see funds with the typical cost structure of 2/20, investment periods that are not aligned with with the nature of the underlying asset or market, and LPA clauses that are more skewed to the benefit of GPs. This is specially true in the MENA region where I believe allot of sponsors launch funds based on replicating strategies and documentation of funds focusing on developed markets, or relying on service providers that draft LPAs based on a standard template.
As private markets become more crowded with capital and managers, some of the inefficiencies — namely the ability to buy companies or assets at a discount, contract. But many others, for example the skill to enhance the operating performance of a business, good governance and oversight, industry insight and the optimal utilization of levers to improve the growth and efficiency of underlying assets are ever evolving and endless.
Commitment & Investment
There are several ways for investors to access private market strategies. These include, fund-of-funds, secondary funds, primary funds, co-investments and direct investments/ direct deals.
Generally speaking, returns, risk and implementation complexity increase as investors move from fund-of-funds to investing in direct investments. What determines the right approach for most investors comes down to resources and available capital.
The same inter-quartile spread that we find in private market funds relative to public market strategies will only grow wider as investors shift up the complexity spectrum to financing direct private investments.
Return data from Thompson Reuters on the private equity universe across primary, secondary and fund-of-fund strategies highlights the return gaps between implementation approaches. Fund-of-funds have underperformed both secondary and primary fund universes by 2.5% and 3.6% annually, respectively over the trailing 20-year period for U.S. focused funds. These results are directionally consistent across European and Global fund universes, as well.
While certain specialty and differentiated fund-of-funds, for example those focused on hard-to-access geographies, may play an additive role in a portfolio, for plans large enough to bear the cost of hiring staff or outsourcing portfolio implementation, a direct private markets portfolio (i.e. primary funds) constituting the bulk of core holdings has the potential for meaningful outperformance. As private markets become more efficient, institutions seeking alpha will have to be increasingly mindful of fees that can deplete excess returns.
Diversify, but not overly so
Plan Prudently and Avoid Hasty Decisions
While careful manager selection is of paramount importance, diversifying by sub-asset class, vintage year, industry, geography and manager teams/organizations can further reduce undue risks. Following a pacing model is a good way to enforce discipline in implementing a private markets program.
Pacing studies serve several functions, one of which is to provide a blueprint for investors to follow to reach their desired target allocation to private asset classes. A pacing study will also provide a projected cash flow budget and help in portfolio design and diversification by sub-asset class and vintage year.
Pacing studies at their basic are cash flow projection models that make a series of assumptions around the “pace” of investor capital contributions and distributions and the growth rate of investments. A good model will have unique assumptions within each underlying strategy. For example, a venture capital strategy will typically draw down capital slower, make distributions much later in the fund life and should have a higher return expectation than a buyout fund’s assumptions.
Modelling sub-asset classes will improve the reliability of the model and provide a better blueprint to follow for investors. As commitments are modelled, investors should be consciously diversifying among investment sub-asset classes and geographies as well as, spacing out commitments to achieve vintage year diversification.
A rule-of-thumb within private equity is to have a 60/25/15 portfolio.
- 60% in Buyouts,
- 25% in Venture Capital/Growth Equity,
- 15% in Distressed Debt/Special Situations
It is important to note that too much diversification is problematic as performance becomes constrained by the lack of differentiation from the “market” portfolio and as fees/costs eat into your returns. Having a more limited number of manager relationships allows investors to better monitor their portfolios and reduce legal and administrative costs. If manager selection is successful, concentration by manager will allow for winners to have a larger impact on performance.
In general, a strategy’s risk and liquidity profile drive how we size individual commitments, thus the least liquid investments like venture capital will have smaller commitments than large-cap buyout or debt-related funds.
Managing The J-Curve
The term j-curve comes from the shape of the cash flows and expected performance that private funds and portfolios tend to exhibit. In the first 1–7 years of a private markets fund life, the manager is drawing down capital to fund investments and pay fees/expenses. The path of cash flows and early fees on committed capital that have had insufficient time to produce an upside on investments results in a negative return in the first few years of a private market fund investment. This j-curve effect can create a meaningful return headwind for investors with large commitments to private funds in the early stages of a private market program’s funding.
Recognizing a general trade-off between achieving a high return versus a high multiple of invested capital (MOIC), some investors build an expectation of an elongated J-curve, while others opt to mitigate the j-curve by utilizing strategies that exhibit little-to-no j-curve.
Two strategies that can help mitigate a deep j-curve are secondary investments and debt strategies. Secondary funds exhibit abnormally high returns early on as investments typically purchased at a discount to NAV are re-valued after the transaction closes, generating an immediate return pop. Debt strategies typically invest capital quicker and importantly provide distributions faster, often within the first year. Relative to investing in equity-oriented funds on a primary basis, debt and secondary funds can mitigate the j-curve, but also tend to produce a lower multiple of capital. Investors must weigh these tradeoffs during portfolio construction.
There is no doubt that private capital markets offer investors access to return drivers and investment skills that are difficult to replicate in public markets. These benefits, combined with the increasing sophistication of asset allocation approaches adopted by institutional investors, as well as the ongoing search for attractive investment returns, have led to substantial growth in private market investing.
However, these benefits are not without challenges. Many investors lack the skills and resources to build a sustainable and disciplined investment model, let alone following through a diligent manager selection process. Similarly, some of the practices and arguments used to advance private markets are questionable — particularly those regarding measuring fund performance and risk mitigation. Furthermore, including private markets in basic Mean Variance Optimization (MVO) calculations raises technical and conceptual issues.
About the author
Amro Al Qubaisi is a private capital markets specialist and governance enthusiast with over 18+ years of banking and finance experience. He has a strong leadership acumen with proven skills in cross-functional collaboration to achieve goals in both start-up and corporate environments.
Amro held multiple senior roles with leading financial institutions such as HSBC and First Abu Dhabi Bank. He has an established track record in fundraising and winning RFPs worth over $20bn. In his current role, Amro houses strategic initiatives for Abu Dhabi and Federal government entities, and oversees their banking needs. Amro is a Microsoft for start-ups mentor, a serial entrepreneur passionate about nurturing new innovations.
Amro has a B.A in international relations from Rollins College, and an MBA from INSEAD. He is a Certified Investment Fund Director, Certified Investor Relations Officer, CAIA and completed the Oxford Private Markets Investment Programme.
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