Han Dieperink: The safe haven of private markets
This column was originally written in Dutch. This is an English translation.
By Han Dieperink, written in a personal capacity
The real risk of investing is permanent loss of wealth. Private markets offer alternatives for risk diversification and stable returns, even in the face of financial fluctuations.
The price equity investors have to pay for the extra return is called risk. The real risk of investing is the permanent loss of wealth. In finance, volatility or volatility is often used as a measure of risk. However, volatility is only a risk if it leads to permanent loss of wealth. This can happen when investors react to volatility by selling positions. Often, volatility at such times is higher than previously agreed. In any risk assessment, an investor accepts a certain level of volatility.
Such accepted risk is effectively no longer risk. Only when volatility is higher than previously agreed, an implicit need to act arises. Volatility can also be an opportunity, an opportunity to realise additional returns (alpha). Indeed, volatility offers an opportunity to buy assets low and then sell them high again. In practice, however, many investors prefer to sell during periods of high volatility. After all, investors have nothing against risk, as long as it does not cost money.
Bonds as protection against equity risk
The traditional way to protect against equity risk is to partially fill a portfolio with bonds. When the equity market falls, falling interest rates cause bond prices to rise, which can partially absorb losses on equities. This assumes that bad news for the stock market is good news for the bond market. This is the case, for instance, when disappointing economic news depresses inflation. However, the correlation between equities and bonds is not always equal. In times of relatively low interest rates (and inflation), the correlation is negative: when equities fall, bonds rise in value.
In contrast, higher (real) interest rates and higher inflation levels are often accompanied by a positive correlation between equities and bonds. This means that the added value of bonds in a mixed portfolio decreases rapidly. Another alternative to spread equity risk is to use private markets. First, by doing so, an investor gives up less return potential. Especially during the years of financial repression, little return was left for the bondholder. An additional aspect of financial repression is that especially risky assets tend to overshoot during such a period.
Private markets as an alternative
This is not surprising, as money is deliberately made too cheap so that borrowers do not have to take the pain. Equities benefit from this, but so do investments in private markets. After all, interest rates play an important role there too. An additional advantage of private markets is that there is much less volatility. This does not mean that there is no risk, but it does mean that investors are less likely to make wrong decisions based on volatility. After all, a lot of trading in the stock market often comes at the expense of returns.
The structure of returns in private markets is also different from the stock market. In equities, over the long term, only a particularly small group of stocks determines total returns. The vast majority of listed shares do not, on balance, yield a return. Indeed, the winners are offset by many losers. The select group of stocks that provide total returns is in danger of getting smaller rather than bigger. So it is not easy to realise this stock return through selection, but those who choose the right shares do achieve much higher returns in the long run.
Risk management and manager selection
In private markets, ex-ante risk management plays a much bigger role. There is much more work with scenarios that can play out when selling, while an equity investor usually does not think about selling when buying. In practice, investments in private markets are much less concentrated than in the stock market. The main difference is that losses are much smaller and profits are more widely distributed. While there are big differences between specific funds in private markets, this has more to do with the expertise of the manager than the market.
This means that private markets are much more about selecting the right manager than selecting the right underlying investment. Furthermore, returns in private markets depend more on when to invest and when to realise the returns. This vintage year effect is due to the market situation at the time of buying and selling, or buying low and selling high. When buying, it helps if everyone is negative, preferably when there is a recession, so that prices are relatively low.
The effect of interest rates on private markets
However, it is then impossible to predict what the situation will look like when selling. This in itself is not a problem because the exact moment of sale is not determined in advance. If things get tough for a while, for instance after a rapid rise in interest rates or during a recession, the moment of sale can often be easily postponed. This has happened in recent years as several investors, due to increased interest rates, wait for a better time to sell.
Next year, private markets will get a boost from interest rates. Most importantly, the long period of rising interest rates is over and thanks to the stabilisation and fall in short-term interest rates in particular, there is more interest in taking risk again. As a result, the price at which the seller wants to sell and the buyer wants to buy will come closer together. It helps that many deals have fallen through in recent years for a variety of reasons, mainly due to regulatory objections.
More deals and new opportunities
This not only ensures that specific deals do not go ahead, but also that investors are cautious about new deals. With far-reaching deregulation under Trump (and if Draghi has his way, also far-reaching deregulation in Europe), there will be fewer objections in terms of mergers and acquisitions. This means not only more deals, but also a flood of deals currently in the pipeline. On top of this, one deal often provokes another. These realisations are often good for overall returns, as conservative valuation means that some additional returns can be achieved precisely at the tail end.
Moreover, this liquidity is often an impetus for new deals. This is an excellent time to use private markets to improve the risk/return profile of a portfolio.