Shrinking public markets see investors look to burgeoning private markets for growth

The investment landscape is changing. The number of publicly listed companies around the world is shrinking – in the mid-1990s the London Stock Exchange boasted over 2,700 companies listed on its main market. By the end of 2023, it had dropped to fewer than 1,100.

Mergers and acquisitions played their part in bringing down the number, as did the growth of private capital which removed the need to list publicly, alongside changing business models which were no longer as reliant on securing significant capital upfront.

The last two drivers reflect a broader change in how businesses operate and raise capital. The most important aspect of which is that many new companies are now able to scale up through private funding. And the upshot is companies are staying private for longer than they used to and their growth is happening away from public markets.

By the time a successful business lists on a major exchange, if indeed it ever does, early growth may already have taken place.

Private markets, therefore, are increasingly seen as an alternative route to returns through the early phases of a business.

But, and it’s a very important but, the higher return potential comes at the expense of  restricted access to capital for five to 10 years. These markets require patience, planning, and a high tolerance for complexity. They are generally best suited to long-term investors with sufficient liquid assets elsewhere.

Giving up the liquidity, transparency, and lower costs of investing in public markets is a decision that should not be taken lightly. There are many things to consider.

Liquidity trade-off: the important ‘but’

The rise in private market investment in recent years  is understandable, offering as they do the possibility for higher returns in an environment where it is increasingly tricky to stay diversified in public markets – due to there being  fewer listings and the sheer weight of influence of some sectors. Case in point, the ‘FAANGs’ – stocks in Facebook (now Meta), Amazon, Apple, Netflix, and Google (or Alphabet as it is now known). It’s a fitting acronym as these five American tech giants have certainly sunk their teeth in to the Nasdaq and the S&P 500. By investing in private markets, you not only gain exposure to the expansion phase of potentially high-growth companies and the possibility therefore of greater capital appreciation. You also gain access to private debt markets, which have expanded significantly in recent years

The trade-off is illiquidity. You must be comfortable with your money being locked in for the long-term. Unlike shares in a FTSE 100 company that you can sell in seconds on an exchange, private market investments operate on fixed timelines. You cannot easily withdraw your money once it is committed to a fund.

This consideration forms the core of the planning work when building a portfolio incorporating private markets. Before allocating funds, your financial planner will stress-test your cash flow.

Typically, short-term living costs, upcoming tax liabilities and medium-term goals should be covered by liquid assets. Private investments tend to be most appropriate when they sit on top of a secure and accessible foundation of liquid assets.

Private debt

Private debt has become a particular focus in recent times and has grown as a proportion of the market. This asset class involves non-bank lenders providing capital directly to private companies.

While the yields are attractive, the underlying borrowers are often mid-sized companies that carry a higher risk of default than large multinational corporations. Lending standards and covenant quality can also vary across the market, which makes due manager selection particularly important.

Often, these loans are senior secured. This means they sit at the top of the capital structure and are backed by the company’s assets. This provides some, but not foolproof, protection for investors in the event the business fails.

Robust due diligence is essential. This includes assessing the credit quality of underlying loans and the manager’s track record in recovering capital if a borrower runs into difficulty.

Complex construction

The mechanical operation of private funds requires specific oversight and cash management. Although not all funds work the same, many do so with the following process:

1. When you invest in a private market fund, you do not transfer your entire investment sum on day one. Instead, you make a legally binding capital commitment.
2. The fund manager then issues ‘capital calls’, where they ask you to contribute some the capital you have committed to provide. The manager will make these ‘calls’ over a period of three to four years as they identify specific businesses to buy. For example, if you commit £500,000 to a private equity fund, you might only transfer £100,000 in the first year. The remaining £400,000 stays in your portfolio, but it must be kept highly liquid so it is ready when the manager requests it.
3. You must hold enough cash in reserve to meet these ‘calls’ when they arrive. Notice periods are often just a few weeks. Failing to meet a capital call can result in heavy financial penalties and a loss of your existing equity in the fund.
4. This is managed by maintaining a buffer of liquid assets within the wider portfolio. This ensures the investor can meet sudden obligations without having to sell other investments at the wrong time.

Reporting and fees

Reporting is another area where private markets differ sharply from public ones. Because the underlying companies are not traded daily, valuations are based on periodic assessments rather than continuous market pricing.

Valuations are typically provided on a quarterly basis and are subject to a reporting time lag. Your portfolio statements will look different and you will not see the regular price fluctuations you are used to with public shares. This is a long way from being able to check your up-to-the-minute portfolio value on a publicly traded stock market. As such it can give the misleading impression that that private market valuations are smoother than public markets simply because they are updated less frequently.

Then there is the matter of cost. Compared to public market funds, private market funds require considerably more hands-on management for sourcing, acquiring, restructuring and selling private companies, with the added operational complexities that comes with that. This typically means higher fees. You will often pay a management fee alongside a performance fee, structured so the manager takes a percentage of the profits only once a specific return level is met.

This structure can create what is known as the ‘J-curve’ effect. In the beginning you may see a sharp drop which is then followed by a steep rise, due to weaker early returns, before investments mature.

The question to explore with your adviser is whether the net return has the potential to outweigh the additional complexity and lack of liquidity – and how those trade-offs fit within the broader structure of your portfolio.

Get in touch:

Please contact your Foster Denovo Partner or email advise-me@fosterdonovo.com or call 0330 332 7866 for more information.

Please note:

This article is for information purposes only and does not constitute advice or a personalised recommendation. It is based on our understanding of current and proposed legislation, which may change.

The value of investments can go down as well as up and you may not get back the full amount invested.

This newsletter is for information purposes only and does not constitute advice or a personalised recommendation.

This newsletter is based on our understanding of current and proposed legislation, which may change.

Foster Denovo Private Wealth is a trading name of Foster Denovo Limited, which is authorised and regulated by the Financial Conduct Authority. Registered office: Foster Denovo Limited, Ruxley House, 2 Hamm Moor Lane, Addlestone, Surrey, KT15 2SA.
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