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Understanding Private Markets

June 28, 2024 10 min 54 sec
Featuring
Srikant Menon
From
CIBC Asset Management
Business people discuss investment project working and planning strategy on digital tablet.
AdobeStock / Natee Meepian
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Text transcript

Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

Srikant Menon, director, alternative investments research, CIBC Asset Management. 

Interest rates play a crucial role in shaping the dynamics of private markets. So when interest rates are high, borrowing costs increase, making it more expensive for companies to finance their operations and growth through debt.  

This scenario can lead to a slowdown in economic activity as both businesses and consumers cut back on spending. For private equity firms, higher interest rates can lead to lower valuations for potential acquisitions, as the cost of leveraging deals rises.  

Conversely, when interest rates decline, the cost of borrowing decreases and creates more investments and spending. Lower interest rates can boost valuations in private markets, as cheaper debt financing makes leveraged buyouts more attractive. Additionally, declining rates can drive investors to seek higher yields in private markets as traditional fixed-income investments offer lower returns. This trend can particularly benefit private equity and venture capital where the ability to access cheap capital is a significant advantage.  

However, the relationship between interest rates and private markets is not always straightforward. Other factors such as economic growth, inflation and market sentiment also play a significant role in determining the impact of interest rates on private markets.  

For instance, if interest rates are declining due to a weakening economy, the positive impact of private markets might be offset by broader economic concerns. Therefore, while declining interest rates can create a favourable environment for private markets, it is essential to consider the broader economic context. Understanding these nuances is crucial for investors looking to navigate the complexities of private markets effectively.  

Recently, a few private funds in Canada, particularly those focused on real estate and private credit, have encountered significant issues. These challenges can have profound implications for investors. So when a private fund faces difficulties, it often leads to a loss of investor confidence, prompting withdrawals that negatively impact the fund’s assets under management. This in turn, limits the fund’s ability to make new investments or support existing ones. 

A common issue among struggling private credit firms is a lack of diversification and concentration risk within their portfolios. As a result, if a few of those investments underperform, which it can, it significantly is a drag on the overall performance of the fund. In the realm of private real estate, problems are most pronounced in funds with overexposure to assets suffering from high vacancy rates, or the inability to pass on inflationary costs, such as office properties. Evergreen funds, holding these assets are experiencing redemption requests that in some instances have reached up to 30% of assets under management, making it difficult to recycle capital without being forced to sell assets, sometimes even at these risk valuations.  

Investors need to conduct thorough due diligence when selecting private funds. Understanding the fund’s strategy, the expertise of its management, and its risk management practices can help mitigate some of the risks associated with private fund investments. Diversification across different funds and asset classes can also provide a buffer against potential troubles in any single fund. 

Private markets offer significant opportunities from an investment standpoint. In the realm of credit, private debt continues to be an attractive option for investors seeking higher yields compared to traditional fixed-income securities. Private credit offers the potential for attractive risk-adjusted returns, especially in an environment where interest rates remain volatile.  

This segment includes direct lending, mezzanine financing, distressed debt — each offering unique opportunities and risks.  

Equity investments in private companies also present compelling opportunities. The ability to invest in companies at various stages of their growth cycle allows investors to capture substantial value creation. From early stage venture capital to later stage buyouts, private equity provides access to a broad spectrum of investment opportunities. Growth equity, in particular, has seen a surge in interest as companies seek to expand and scale their operations without going public.  

Infrastructure investments have become increasingly popular, driven by the need for significant upgrades and expansion in both developed and emerging markets. These investments offer stable cash flows and long-term growth potential, making them an attractive option for institutional investors and retail investors looking for diversification and inflation protection. Infrastructure assets, such as energy, transportation, telecommunication are essential for economic development, and can provide reliable returns over extended periods.  

And finally, real estate continues to be a cornerstone of private markets. The demand for high-quality properties in prime locations remains robust, offering steady income streams and potential for capital appreciation. Additionally, trends such as urbanization and the growth of e-commerce are creating new opportunities in sectors like logistics and data centre.  

Innovation and technology, sustainability initiatives and demographic shifts are constantly creating new opportunities. For example, the push for renewable energy and sustainable practices is driving investments in green infrastructure and clean technology. Staying ahead of these trends can help one identify promising opportunities and make informed decisions.  

When comparing risk-adjusted returns between credit and equity, it’s essential to consider the different risk profiles and return characteristics of each asset class. Private credit investments typically offer more stable and predictable cash flows compared to equity investments. This stability is due to the contraction nature of debt payments, which are often secured by the borrower’s assets. Investors in private credit can benefit from regular interest payments and in some cases collateral protection.  

In contrast, equity investments come with higher potential returns but also greater risks. The value of equity investments in private businesses can be highly volatile, driven by factors such as market conditions, company performance and broader economic trends. However, the upside potential in these equity investments can be substantial, especially for successful growth companies. Private equity investors often seek to add value through operational improvements, strategic guidance and market expansion, aiming for significant capital acquisition.  

Investors seeking a balanced approach often allocate to both credit and equity within their portfolios. This strategy allows them to benefit from the stability and income provided by private credit, while capturing the upside potential of equity investments. By diversifying across these asset classes, investors can achieve a more balanced risk/return profile. 

Lastly, it’s crucial to discuss the risks to the private market sector. One of the primary risks is illiquidity. Private market investments are not traded on public exchanges, making them difficult to sell quickly. Investors and funds typically have to hold these investments for several years before they can exit. This lack of liquidity can be problematic if investors need access to their capital in short order.  

Recent product innovations can offer advantages that alleviate liquidity concerns to some extent and provide easier access to private markets. These evergreen products may feature structured liquidity mechanisms, such as predefined redemption windows that help manage the illiquidity typically associated with private assets. This structure allows investors to plan their liquidity needs more effectively. However, it is important that the liquidity feature in retail investment products should be viewed as safety nets for unforeseen personal financial needs, and not as a tool for frequent asset reallocation or market timing. Investors must understand that these features are not designed for active trading, and the misuse can lead to market distortions.  

While private market investments offer the potential for higher returns and portfolio diversification, Investors must carefully consider these risks and ensure that their risk tolerance and investment horizon aligns with the illiquid nature of these investments.