Editor's note: This article first appeared in the Q2 2022 issue of Morningstar magazine. Click here to subscribe. One could say that Morningstar in a small way symbolizes the convergence of private and public markets. The company, long known for its coverage of public funds and stocks, acquired private-markets platform PitchBook in 2016 to add to its investment-analysis capabilities. In purchasing PitchBook, Morningstar was responding to the rapidly growing interest from investors for research and data on private capital markets. Today, assets continue to pour into private markets.
As you’ve read in the Spotlight section, the mainstreaming of private-markets investing has begun. For advisors and their clients, the question is whether they should consider adding private investments to their portfolios. For insight, we talked with two experts on public and private markets, one each from Morningstar and PitchBook. Hilary Wiek, based in Seattle, works in PitchBook’s institutional research group and is the lead analyst on fund strategies and performance, covering everything related to private equity, venture capital, real assets, and other private-markets strategies. Simon Scott is based in Morningstar’s Sydney office and is director of alternatives ratings on the global manager research team. Our conversation took place March 9 and has been edited for length and clarity.
John Rekenthaler: The convergence of private and public equity is a phrase that is often used, but what does the term mean to each of you?
Hilary Wiek: There are a lot of things going on with that phrase. Investors who haven't had access to private equity are trying to figure out how they can get in. Private-market players also are using public markets to implement their strategies or, in the case of some private-market fund managers, going public themselves. So, you've got the KKRs, Apollos, and Areses of the world that are publicly traded but offer private strategies.
Simon Scott: I think of it like a Venn diagram. You've got two kinds of distinct capital pools. Each has very different industry relationships, and they're coming together. Technological and financial innovation has allowed them to converge and play on each other's turf. That means they're trying to gain access to the informational advantages of one side or the capital duration advantages of the other.
For the companies that are the targets of these groups—great, you’ve now got double the market to play with. You can partner up with a hedge fund, which traditionally is much more hands-off; hedge fund managers don’t require board seats, and they can be more of a longer-term, lifecycle investor. Or, if you need operational expertise, you’ve got the choice of partnering with the wider private equity market.
Wiek: You've also got public-market managers putting private assets into their public-market portfolios. Up to 15% of a U.S. mutual fund can be in illiquid investments. We're finding small-cap managers who have been recently shut out from investing in companies they used to be able to buy because they're staying private longer, going into pre-IPO companies and having a less liquid profile overall.
Scott: We've seen that in debt as well. The first interval funds—which are at the more liquid end of the private-market spectrum—are in credit. In commodities, accessing Chinese futures for years has been done via a swap. Whether you count it as a derivative or as a private asset, either way, it's not publicly traded.
Laying the Groundwork
Rekenthaler: There's a lot of activity going on, but these are things that haven't much affected the typical financial advisor and the typical client yet.
Wiek: In 2020, the Trump administration's Department of Labor said it was OK to put private equity into 401(k) plans. When I looked six months after the announcement, I couldn't find any actual products hitting that market yet, but I saw a lot of articles from money managers saying why it was a good idea. So, I think the industry is laying the groundwork to get regular people thinking about private equity. We're already seeing wealth-management firms aggregating smaller commitments to help individual investors get into a fund.
Scott: With the growth in data, courtesy of companies like PitchBook, we will see more third-party companies—call them aggregators or platforms—coming to the fore to provide liquidity to these markets. That's the missing layer that will take these investments from a purely institutional space to one that is more mainstream.
Rekenthaler: That's a strong point. Morningstar's growth was tied to the mutual fund industry growth in the 1980s. As the industry grew, more people became interested. The Wall Street Journal started covering mutual funds daily. Now there was a wealth of information to make people feel comfortable about investing. With private equity, we may see the same dynamic as more information becomes available.
Wiek: That might be true, but sitting here at PitchBook, where we aggregate private-market data that is, based on the title, private, I can say that the data is hard to come by. Yes, we make a lot of our research pieces freely available, but our data is behind a paywall. And it's pretty expensive, especially for an individual investor. So, I think there's still going to be an informational advantage for people who can afford to access private-market information. PitchBook exists because this is hard-to-find data. This isn't information investors can get on Yahoo Finance.
Rekenthaler: Simon, as I understand it, some countries are further along on the convergence than the U.S.
Scott: Americans are used to having very efficient, sophisticated capital markets. Historically in other parts of the world, that hasn't been the case. It's only in the last 20 to 30 years when many international markets have started catching up. So, outside of the U.S., there is a greater acceptance for nonfinancial assets; they're perceived as being more normal. Physical, tangible assets have always had a strong appeal because you've had low trust in government regimes. You've had less urbanization. Therefore, things like bullion, real estate, other kinds of nonfinancial assets have always been front of mind in these other markets.
In Asia and India, for example, more than half of the largest companies are still family-owned. Within Europe, in France and Germany, between 35% and 40% of the companies above a billion dollars in revenue are family companies. So, investors in these regions have a greater familiarity with the operation of private companies.
Australia sits in the middle. We’re a regulated market. We’ve got a universal compulsory savings approach for retirement: 10.5% of our salary is automatically paid into a pension fund each month by our employer. Consequently, for a nation of just under 30 million people, we’ve got a $3.5 trillion pension industry. Within that, private assets—I’m talking equity, debt, infrastructure, agriculture—are about 20% of people’s portfolios.
We wrote a couple of reports at the start of the year about the record inflows into liquid alternatives in 2021, and it was quite interesting. Flows into liquid alts in the U.S. was all about diversifying away from equity exposure into hedged equity products. In Australia, two of the three largest products based on retail flows were open-ended private equity vehicles. In other words, there was a demand to retain equity exposure, but to modify it.
For me, sitting in Sydney, I can invest in a single-manager private equity fund on the Sydney stock exchange. We’ve got funds that combine private equity, infrastructure, water, and other sorts of private agricultural assets—again, all available on the exchange. We’ve also got interval funds, and then obviously, we’ve got pension options, which are unlisted. We’ve got multi-asset funds that invest in the space. So, the average Australian investor has an abundance of choice of private-market access points.
But Australia isn’t a panacea. Much like the SEC is starting to look at investor protections in the U.S. and making it a public-policy issue, we’re certainly having similar discussions in Australia. Ensuring there’s a level playing field is front of mind of regulators. Funds, unsurprisingly in a $3.5 trillion industry, rallied against any form of disclosure. Their argument was interesting. They said that having commercially sensitive information available would put them at a competitive disadvantage in future transactions and that they should only have to provide a valuation range, which just seems completely inappropriate. I don’t know, Hilary, if you’ve seen funds move to that I’ll-provide-a-range model. But how on earth do you keep them accountable when the price valuation is a range between X and Y?
Wiek: It's funny. A pension plan in California was trying to hide its private debt information behind a wall, so it couldn't have a Freedom of Information Act filing against it. It was like, "We want to make sure that these investments do the best they can, and if we made that information public, that could be a problem." So, yes, it's certainly not an argument that is unheard of.
Data vs. Information
Rekenthaler: You both raise interesting points about the cultural differences between public and private markets. The U.S. has been the land of Jack Bogle, where retail investors have become accustomed to tremendous amounts of transparency. You can see the portfolios and prices of exchange-traded funds in real time.
How does it work, say, in the Australian private equity funds? What are the liquidity terms and the expectations of investors? How would this work in the U.S.? Would we need to change our mindset, or would private equity providers need to change?
Scott: I'm an advocate for disclosure, but it must have a purpose. So, yes, I can see every company in a public portfolio, but do I need to see what a building at 60 Park Avenue is valued at 9:58 on a Tuesday morning in Sydney? Not tremendously. I need to broadly know what's there to be able to use it in a portfolio. "OK, I've got U.S. office exposure on the East Coast" or "I'm subject to X market forces." I think we need knowledge, but we don't need to go into the weeds on a daily basis. This is the fine line between the trust-me angle that the fund-management companies push and meeting the fiduciary duties or advisory duties to your clients. It's always been a tug of war between the level of information and the time required to review it.
How it works in Australia is vehicle-dependent, but it comes back to the valuation metrics and liquidity. We know valuation is the problem from an advisory standpoint. You’ve got a plethora of metrics being thrown at you. Do I look at the return on investment? Do I look at the multiples on invested capital? How do I assess whether my manager’s doing a good job? It’s near impossible, because the system can be gamed much more than it can in public equities.
Wiek: I've always said that there's a big difference between data and information. Transparency could give you data, but it's not necessarily giving you any information. Transparency can give people some false comfort: "Oh, look, I have a valuation every day. It must be right." But in private markets, there's a lot of sticking your finger in the air and coming up with something that seems about right.
You have to base valuations on things like public comparables, so people say, “My company’s just like that unicorn IPO, so I’m going to give my company the same multiple.” Well, your company may actually be nothing like it. You can be as transparent as you want, but it’s not money in the bank until you’ve actually sold the thing.
Scott: The other point on that—and this is a bit I really struggle with—is that the sales message for a lot of these private funds is that they operate away from all the noise and sentiment in public markets, and that's why this is a better investment. Yet at the same time, they say, "Oh, but we'll take those public-market multiples, which include all that sentiment and noise, in order to generate our valuations." To me, that makes no sense.
Wiek: Part of that harks back to the financial crisis. The rules changed. When I first started looking at private equity around the year 2000, companies tended to not change their valuations unless there was an event—they got a new funding round, or they sold a piece of the company. But in the financial crisis, when your private-market portfolio valuation stayed here and your public-market portfolio sank to there, suddenly it appeared that you've got this huge exposure to private equity, when in reality, it should be moving somewhat with the market. Maybe things have tilted too far in using public-market comps, but I think that the other way allowed for a bit less obfuscation. You're putting valuation on a company, but as I said, it may not be information. Until the company is sold, I wouldn't put a lot of faith in it.
Rekenthaler: There's been a push to get private equity in 401(k) plans—in target-date funds specifically. But what if one fund has a 10% position in private equity and one does not? If the private equity sleeve is valued at book and the market goes up, the fund with private equity will trail its competitor. But if that sleeve is priced on a mark-to-market comparable, then there's temptation to price these things aggressively.
Scott: That's an issue we are looking at. There is a vast difference between, say, a fund that is listed on an exchange each day and must have a live unit price versus a pension plan, which can have much more periodic pricing. You can have the same pool of assets, and one is returning 20% a year and the other one's valuation hasn't moved.
The second part of that is the time lag for transactions. We’re having this conversation in early March. Say I want to exit my position at the end of March; I have to put my notification in today. That unit price won’t be given to me until almost late April, with the proceeds coming back to me in late May. So, I’ve got a very loose idea of what I’m going to get and when I’m going to get it. With everything that has occurred in the markets this year, I’m really not sure what value my redemption is going to be struck at. That vagueness is going to prohibit the growth of this marketplace into more retail portfolios.
Wiek: This is why pensions were some of the early investors into private equity; it's a better match of long-termism. Pensions know how many years until they have to pay out their pensions. So, they can buy long-term assets and not have to think about interquarter, intermonth gyrations. Having a mismatch between your objectives and the investments you're in is problematic no matter what you're investing in.
Why Own Private Equity?
Rekenthaler: From the retail perspective, it almost seems as if a new type of vehicle needs to be invented. Rather than trying to shoehorn private equity into even interval funds, create a vehicle that offers more liquidity and more frequent pricing.
Scott: Fundamentally, however, if you want to invest in this space, why are you expecting liquidity? I had the same issue 10, 15 years ago with hedge funds. It just seems counter to the whole reason that you want to invest here in the first place. So, I think investors really need to question themselves. If they need liquidity, is private equity the right place to park their dollars?
Rekenthaler: For a conventional, everyday person like myself, the natural question is: Why would I want to own private equity?
Wiek: Like every investment trend we've all seen in our careers, money follows returns. I've put out the fund performance report for PitchBook every quarter, and venture capital returns were over 50% in the last year.
Rekenthaler: Well, there's the answer.
Wiek: Maybe it never happens again, or maybe those are based on valuations that are unrealized. But when people see that published headline number, they're going to say, "Wait, venture capital? How do I get some of that?"
People believe that there’s an illiquidity premium, that by taking the risk of not being able to get your money back when you want it, by being more patient, and by giving the company the opportunity to think long term, to roll up their sleeves to make a better company, that you can get better returns out of private equity than you can out of public equity.
Some of it goes back to the efficient-market hypothesis—that in the public markets, if most information is out there, everything’s priced pretty fairly and, therefore, there may not be much upside over the market return. But in the private markets, where information isn’t flowing freely as much, there’s more opportunity for money to be made. So, a lot of it can be theoretical, but I think those are the general arguments for why private equity seems like a really interesting place to be for a lot of folks.
Rekenthaler: The quoted returns have been strong for private equity, although there are issues about how those returns are calculated. It seems there are excess gains to be had, at least in certain parts of the cycle.
Wiek: Right. The returns numbers that PitchBook reports are net of fees—actually, they're net of institutional fees. They're not calculated based on what retail investors would pay. Retail investors, if they're investing in a fund of funds through an aggregator, such as their local broker, are paying fees to the fund manager, the fund-of-funds managers, and the broker. They aren't getting the headline numbers that PitchBook reports.
Scott: If I'm holding a 60/40 portfolio and want to include private equity, and I look at the sector weights of the S&P 500 or the Morningstar US Market Index and then look at where private equity money is going, what am I doing other than just targeting the same sectors but off-market? Am I really adding diversification to my portfolio?
I’ve seen the stories that companies are staying private for longer and that’s where the growth’s happening. I can see why people would want a piece of that. But ultimately, private equity is still, to me, being sold on that mythical illiquidity premium. I’ve yet to see anyone quantify it, and I certainly have yet to meet an investor going into an investment saying, “Ooh, this is what I expect in exchange for tying up my capital for 10 years—for the opportunity cost, the actual expenses, the lack of disclosure, the lack of regulation, the leverage, for the complexity risk, and so on.”
Investors don’t put all this together before they invest. Instead, it’s, “I’ll give you my money, and then you tell me in 10 years what this illiquidity premium is.” I wish someone could tell me today what the premium is, because it’s certainly not in my datasets.
Wiek: You're right. You could find studies that show it both ways. Depending on the time period, there are absolutely times where private equity's done a lot better than public equity, and that gets ascribed to the mythical illiquidity premium. Now, I've always been a believer in private equity, because I like the idea of the firms actually having some say over how a company is run, instead of a mutual fund manager buying a basket of stocks whose management they hope is good. Private equity folks get to make a company better, with long-term thinking and an infusion of capital.
Scott: But isn't that assuming that the management of these companies is somehow subpar to the operational experts who work for private equity companies? It's almost like saying that one set of managers is incompetent, and the other set possesses all of the skills.
Wiek: To me, it's more about that when private money comes in, it's a moment of change. In public companies, management is entrenched. They're going to do everything they can to stay, and it's pretty hard to get them removed. But in private equity, as soon as they come in, a lot of times they replace management. Or it's an opportunity for the founders to get out and to bring in professional managers. Things like that.
But I freely admit that my arguments for private equity are theoretical, that you do have to do a lot of due diligence to try to identify the fund managers who you think are actually good at implementing their vision.
Implementation is key. Private-market managers have a much wider dispersion of returns between top and bottom performance quartiles than public managers do. So yes, you absolutely need to find the ones with skill.
Rekenthaler: In the U.S. marketplace, money's flowing into passive funds and out of actively managed funds. There are exceptions to the rule in more specialized investment areas. Will private equity be one of these exceptions, or will people have access to low-cost, commodity-type index products for private equity?
Scott: Wall Street will always make a solution and sell the dream. So yes, there will be products out there.
It’s interesting, because in the hedge fund space, we rate a fund from Goldman Sachs Asset Management’s quant team. It aims to replicate the hedge fund market, and in my view, they do that very well. However, the issue here is that the vast majority of hedge funds are long-short equity funds. So, when you’re replicating that, it’s got limited portfolio appeal, because basically other factors can’t shine through in that portfolio. You’re basically just buying another equity fund.
I think private equity’s even harder to replicate. There are probably some ways you could do it. We’ve heard people say that one way is to find small-cap managers with low EBITDA and modest leverage. In Canada, there’s a private equity replicator that essentially tries to select the same high-growth industries that private equity managers are investing in, match the metrics in aggregate of what the managers are doing, add a bit of leverage, and then maybe some options as an overlay. So, people are trying.
But if you overlay the Morningstar Developed Europe Mid Cap Target Market Exposure Index on top of one of the longest-running open-end private equity funds that we cover in Europe, you’ve essentially replicated it. There’s no need to buy some form of an overly engineered product. You can match the vast majority of these returns from other segments of public markets.
Wiek: Morningstar and PitchBook recently launched the Developed Markets Listed Private Equity Index, which tracks publicly traded companies with significant private equity exposure. That's not necessarily going to be indicative of what the whole private equity industry's doing. But it gives investors exposure to the businesses of these large asset managers who manage private equity.
Rekenthaler: That might not be a bad thing. The stocks of publicly traded mutual fund companies are notorious for outperforming their mutual funds.
Wiek: Blackstone BX and KKR KKR have every strategy you can think of under the sun, as do many others. So, you're getting exposure to the private equity industry. I think a lot of people are happy with that. But these stocks have the same problems that REITs have in replicating real estate—if you look at the short-term correlations, they move more with the market's stock prices than they move with real estate. In the short term, both public and private equity firms and REITs will move with their industries. But in the longer term, it's going to be more about the businesses that are actually kicking out the cash flows.
Scott: Blackstone has been quite clear, now that they're listed, that they want that recurring management fee. It's less about the general partner's performance fees. This should give investors a return more aligned with the assets that these firms own. It isn't a bad way to have exposure to the sector. Combine that with some mid-cap or other types of public exposures, and it probably captures enough to benefit the average person holding a 60/40 portfolio.
John Rekenthaler is a vice president with Morningstar Research Services LLC.