Our panel of specialists provides insights into the characteristics of private markets, forces behind their recent boom, and the circumstances in which they may “work” for individual investors.

With the economy and equity bull market extending past the decade mark, investors continue to face the urgent challenge of how to best allocate portfolios to generate appreciation potential and income, while mitigating against volatility. A key issue has been whether to diversify into less traditional assets, with private markets taking a central role in that discussion. In this roundtable, Stephanie Luedke, Head of Private Wealth, moderates a panel of Neuberger Berman investment professionals who explore private equity and debt, and their potential role in portfolios.

Stephanie Luedke:

Sultan, how do you and the Investment Strategy Group think about private assets in relation to individual portfolios?

Sultan Khan:

Private markets have a number of appealing characteristics. They are less efficient than public markets, which means that managers generally can better capitalize on informational advantages. Managers also tend to think more like owners: They may look to make fundamental, operational improvements to portfolio companies. Finally, they are not beholden to quarterly reporting like public companies, so they can take a longer-term approach. That said, private equity opportunities take a long time to develop, so investors must be willing to have a long lockup period, for which they should require a potential liquidity premium.

These characteristics have historically contributed to outperformance versus traditional asset classes—between 2% and 6% on an annualized basis, depending on the time horizon you consider (see display). Moreover, the patterns of returns provided by private markets have been quite different, so they have offered particularly effective diversification—something that’s attractive in a “late cycle” period like we’re in today, when traditional assets have tended to see correlations increase.

Private Equity vs. Public Equity Performance

Annualized Returns – Periods Ending June 2019

Asset Matters: Demystifying Private Markets Chart 1

Source: Cambridge Associates. Represents pooled horizon IRR and first-quartile return for the Global All Private Equity Index from Cambridge Associates as of June 2019, which is the latest data available. Index is unmanaged and not available for direct investment. Past performance is not indicative of future results.

Stephanie Luedke:

Elizabeth, can you give us a brief overview of the private equity sectors?

Elizabeth Traxler:

Buyout investing is perhaps the most well-known, where the private equity manager will purchase control of the company with the aim of generating value by professionalizing the business, more effectively managing cash flows, and/or introducing strategic changes. “Buy and build” is a common approach, and often involves acquisitions in a nearby geography or related product area. In larger companies, it can take more dramatic actions to move the needle, so, for example, the manager may look to divest certain businesses that don’t fit the broader organization. Buyouts typically involve more mature businesses, and investors often have an expectation of steady returns, supported by a combination of financial and operational improvements.

Venture capital is quite different. The businesses are often much younger. They may be growing revenues rapidly but have negative cash flows, so they usually need regular infusions of capital to expand into new markets or reach new customers. Often they are still owned by the founders or a small group of angel investors, and venture capitalists come in as minority owners.

Given the higher risk of individual deals, venture funds are likely to include 30 to 40 portfolio companies, compared to perhaps 10 to 15 in a buyout fund. While the manager hopes that all the deals in a buyout fund will be successful, a venture fund may rely on only three or four to generate its entire return.

One of the virtues of private equity is the array of available investments. There are about 8,000 private equity funds,1 which may include small-, mid- and large-cap buyout and venture funds, but also special situations, which involve restructuring distressed companies, and growth capital, where the investor works with an owner or entrepreneur in providing capital to help the company grow.

Stephanie Luedke:

Private credit is a burgeoning area with different fundamentals. Matthew, can you give us a quick overview?

Matthew Bird:

Essentially, private credit or debt involves privately negotiated loans to companies, whether those companies are public or private. The private market stands out relative to public bond offerings and broadly syndicated loans in that it affords more flexibility to companies, and is typically better suited to smaller businesses. In fact, most of the activity we see involves issuers with up to $100 million of earnings.2 As companies get bigger than that, they typically look to public markets for financing.

Private debt managers generally take a conservative approach; unlike private equity and venture capital, credit quality and avoiding loss of principal is a key concern. So, private debt managers seek as much certainty in an underwriting as possible. Is the business able to support this amount of debt? Will it be able to pay the interest, and ultimately the principal on the loan? They look for businesses that have a consistent track record of cash-flow generation, which should be able to support their debt across an economic cycle. They also want to invest in the portion of the capital structure that aligns with their risk levels.

Drivers of Private Market Growth

Stephanie Luedke:

Private equity is booming. What accounts for this trend?

Elizabeth Traxler:

There are a few reasons, including demand for high return potential, supply of deal flow, and a preference by many companies to stay private.

Sultan noted the historical return advantage of private equity over public markets. If you actually look at the median return of private equity vintages since 2000, they have been consistently positive, ranging from 8% to 18%.3 Obviously, liquidity is an issue, but return volatility is generally much less than in public markets—something that investors are looking for these days.

Deal supply has increased in large part because of high valuations, which encourage owners to sell their companies. This has drawn money into the private markets and also fostered deals between private equity groups. Still, the overall effect has been net distributions from private funds. Those who want to maintain existing investment exposure therefore have to reinvest—something that has helped maintain the velocity of deal flow.

Finally, many companies prefer to stay private these days. If you look at the last 20 years, the number of public companies in the U.S. has been cut in half, while the number of private companies has quadrupled. Although there are a few reasons, one is the high cost of running a public company, including reporting requirements and regulation. Also, companies realize that making changes to operations may be harder in the public context, where they are subject to quarterly earnings pressure. Those that launch IPOs often do so later and at larger sizes.

Stephanie Luedke:

Private debt has also expanded rapidly in recent years. What’s driving that?

Matthew Bird:

It’s largely a function of the growth in private equity, combined with the compelling investment characteristics of private debt. Private equity funds typically acquire a business with a limited amount of equity and finance the rest with debt. So, as the supply of deals have increased, the need for private credit has grown as well.

The premium for illiquidity and complexity that is applied to private equity pricing also applies to private debt. Many of the companies that issue private debt are smaller than those issuing high yield and debt offerings, but they often have a similar risk profile. Private debt deals, which are negotiated, offer the borrower a more flexible solution than they would get elsewhere. Importantly, they will generally provide a higher interest rate to the investor than might be available in public markets.

Private Credit Yield Premium

Asset Matters: Demystifying Private Markets Chart 2

Source: Bloomberg, Credit Suisse, Barclays and JP Morgan. Data as of October 2019. Yields represent U.S. Government Generic 10-Year Index, Barclays Corporate Investment Grade Index, Credit Suisse Leveraged Loans 1st Lien Index, JP Morgan Corporate High Yield Bond Index.

Current Approaches

Stephanie Luedke:

Elizabeth, how are you approaching private equity investing in the current environment?

Elizabeth Traxler:

With private equity, there are typically a number of levers that can create returns. One is your purchase price. Similar to public equities, if you buy at a low multiple and sell at a high multiple, you can generate attractive returns. Given the full valuation environment we are in today, we actually are anticipating no multiple expansion and potentially some multiple compression. We believe the majority of returns will likely come from managers transforming businesses. This will involve growing the company, improving operations, unlocking cash flows and creating a more resilient business. Meaningful equity value can be generated by both de-levering and exiting off of a higher earnings base, even if the valuation is at the same multiple at entry/exit. Acquisitions are also a common way to create value, both by buying at accretive valuations and diversifying customer, geographic and product bases.

Stephanie Luedke:

Rather than multiple expansion, then, it sounds like success now relies more on identifying strategies and managers with the potential to create value.

Elizabeth Traxler:

I would agree. Someone asked me the other day, what’s the most important thing to look at in assessing a private equity manager? Most people think it’s going to be prior performance, but to me it’s the team, with prior performance in second place. Because if the current team did not create the past results, then whom are you really backing? This is a long-term asset class and it is important to have a consistent, stable group that has actually built the track record and will stay with the firm to help manage those companies and create value over time. It is also important to see how the manager will deploy the larger funds that most managers are raising. It is easier to underwrite their ability to achieve their prior performance at a larger scale if they have added to their team and resources.

Stephanie Luedke:

Matthew, what’s your take on current conditions?

Matthew Bird:

It’s very hard to call a market turn, but we are more than 10 years into the current market cycle, and at some point things are going to turn. So, I believe it’s important to be thoughtful and not take outsized risk. Today, in my view, this translates into avoiding deeply cyclical, highly capital-intensive businesses, and focusing on private equity sponsors that have done a good job across economic cycles and that have capital to support underperforming businesses. If you look at the last recession, businesses with sustainable capital structures and credible backing generally did just fine; those without those resources were less fortunate.

Finally, it is important to be a long-term investor. Even those investors who entered the space at the market top in 2008 have generally been able to make money, assuming they adopted a long-term view of the asset class and remained invested. The biggest risk in the credit business is that you invest at a peak and then you lose confidence in the markets and pull your money at the worst time. But in private debt, investors that have a long-term vision, pick the right managers and stick with it have the potential to do well over time.

Nuts and Bolts: Gaining Access

Stephanie Luedke:

How do you access private equity strategies?

Elizabeth Traxler:

The main way is through what’s called a primary fund, which places money directly in portfolio companies. These funds have a life of around 10 years. You make an initial capital commitment, which the manager will generally draw on over four or five years, after which your investments will be harvested (and returned to you) over another five years or so.

Given the high investment minimums, it is hard for individuals to achieve diversification through a single fund, so many choose a fund-of-fund structure, where instead of 10 to 15 companies you may have exposure to 400 or 500. Also, funds of funds often have more tools at their disposal to put capital to work more quickly, sometimes using co-investments (investing alongside a manager in a specific deal) or secondary investments (existing private funds that are further into their life span). Investors can invest directly in these products as well. Co-investments may be more diversified than primary funds while secondaries can limit or avoid the long period of outflows that is typical for primary funds.

Stephanie Luedke:

Investment minimums and qualifications can be roadblocks for individuals, but in general private markets are becoming more accessible. Can you explain?

Elizabeth Traxler:

In the past five years, newer products have been introduced called “Accredited Investor Qualified Client products.” They’ve lowered the previous net worth minimum from $5 million to $2 million, while reducing investment minimums as well—sometimes to as low as $50,000. However, many offer the same opportunity sets and risk/return characteristics as traditional funds. Where appropriate, these products can be a great way to access the market.

Stephanie Luedke:

Are private debt vehicles structured similarly to private equity?

Matthew Bird:

The investment structures are very similar, and include primary funds, co-investment and secondaries. Private debt is also available through Business Development Companies or BDCs, which are private-credit-focused platforms that employ equity and leverage, and are in many cases publicly traded.

A key nuance on the private debt side relates to diversification. Typically, in private equity, it makes sense to diversify across funds in light of their sector concentration and limited number of portfolio companies. However, with private debt, a given fund may include far many more deals, from across industries. So, rather than seek diversification across strategies, it is more important to pick a competent private credit manager.

Implementation

Stephanie Luedke:

That’s a good segue to implementation. Sultan, how much should investors consider devoting to private markets?

Sultan Khan:

Generally speaking, private market investments have historically not only enhanced return but also diversified and reduced overall portfolio risk. That’s particularly relevant as we move into what many consider the late stages of the current economic cycle, when traditional assets have tended to exhibit higher correlations to one another.

Although individual circumstances vary, we typically favor introducing about a 10% exposure to the asset class for a moderate investment profile. The firm’s Asset Allocation Committee currently has a 12-month overweight view of private equity and debt, which would push that figure a bit higher. However, much depends on the state of your current portfolio, and how willing you are to tie up your liquidity. After a long bull market, many investors are overweighted to equities relative to their strategic asset allocation. If they seek to redeploy those assets, where feasible they may want the higher return potential of private equity, or they may prefer the lower risk profile and more frequent income stream that can come from private debt. A key way you manage private market risk is through diversification, and we favor spreading risk across vintages, strategies and managers.

Stephanie Luedke:

How can you handle the cash-flow issues tied to private investments?

Sultan Khan:

With public markets, you usually can become fully invested quickly. But private markets have a different cash-flow pattern. As Elizabeth mentioned, once an investor has signed on, the manager does not make capital calls until it’s ready to deploy assets—a process that can sometimes take four or five years. And then the investor will likely see distributions over another five, as investments are harvested.

So it’s hard to time the inflows and outflows. If you decide to invest a million dollars in private equity, you will likely be exposed to 60% to 70% of that, or $600,000 to $700,000 at any given moment. To generate exposure of a full $1 million, you might need to overcommit assets, deploying $1.2 million to $1.5 million.

Effectively managing the capital you have committed is important. Assume that you invest $1 million and 25% is called in the first year. What do you do with the rest? You don’t want it to be a drag on your portfolio return. We typically suggest that if the capital will be called within the first three months, you set aside that amount in cash and cash equivalents. From three to 12 months, you may consider short-duration securities to earn some extra yield. If longer than a year, you may wish to invest with more risk—but again that depends on your personal circumstances and investor profile.

Stephanie Luedke:

How important is manager selection?

Sultan Khan:

It is extremely important in the private space. If you compare an average private equity manager to a top-quartile private equity manager, there has been a pretty large performance dispersion. According to data from Cambridge Associates, over the last 10 years, the average private equity manager has generated an annual return of about 14%.4 But top-quartile managers have generated another 10 percentage points of return, compared to a much narrower gap for managers in public markets. So, it has definitely been rewarding to be selective. Choosing managers based on experience, deal access and performance history could help improve your chances of success.

Stephanie Luedke:

Thanks, everyone.