Why invest in private markets – the illiquidity premium and beyond

While there is ongoing debate about the actual historic outperformance of private markets if leverage risks and fees etc. are properly accounted for, it is generally agreed today that illiquid investments’ common inefficiencies have enabled investors to collect a return premium.

That is estimated to be more than 3% per annum compared to an equivalent liquid investment (see ‘Private Equity Performance: What Do We Know?’ Robert S. Harris, Tim Jenkinson and Steven N. Kaplan, SSRN, April 2013). This difference is commonly referred to as the ‘illiquidity premium’ – an excess return investors earn for not being able to immediately redeem or sell their investment.

Aside from increasing discomfort with public markets, and a requirement for high returns, there are three additional aspects suggesting that most clients should make a significant allocation:

1. Diversification. Private markets offer access to strategies not readily available via public markets investing (e.g. distressed/turnaround situations, private credit, etc.).
2. Growing opportunity set. The number of publicly-listed companies has been shrinking since the early 2000s, whereas the number of private equity-owned companies has been continuously increasing. This trend is not only present in the US, but in all mature public markets, including Europe, China and India (see ‘What caught my eye? V. 110 – The rise and fall of public equity markets’, Viktor Shvets, Perry Yeung, Macquarie Research, April 2019). Consequently, investors who only focus on public markets are missing an increasingly large opportunity set.
3. Benefits of patient investing. Investing in illiquid assets naturally fosters a long-term view and a related focus on appropriate asset allocation, as opposed to short-term tactical plays. We think such an approach is highly beneficial, as empirical studies have shown that private investors typically fail to match the potential performance of a long-term buy-and-hold strategy because they tend to: (a) trade too frequently, (b) rebalance their portfolio too often, and/or (c) seek to time the market (see e.g. ‘Trading is hazardous to your wealth: The common stock investment performance of individual investors’, Brad M. Barber, Terrance Odean – The Journal of Finance, April 2000). All these activities increase transaction and opportunity costs, which can be mitigated or avoided with a long-term and patient investment approach.

How to invest in private markets

While the ‘why’ is quickly and easily understood, the question of ‘how to invest’ poses a challenge to clients and wealth managers alike. At Julius Baer, we provide our clients with end-to-end advice and support them across the value chain, enabling them to select the right fit for their needs in the following ways: 

1. Use cost-efficient structures and be conscious of fees. Private markets funds are predominantly raised with large institutional investors and require large minimum investment amounts, typically in the range of USD 5-10 million. As a result, providers often set up feeder structures in order to aggregate smaller investment amounts. Such feeder structures can be costly and carry large fixed-cost elements (size matters!). Investors should, therefore, carefully examine the different fee layers involved in a private markets products, as well as other aspects such as transferability to another bank.
2. Use an open platform. The relatively opaque market and wide dispersion of returns makes manager selection a key performance driver in private markets investing. An unconstrained universe is critical for identifying and accessing top quartile managers. Finally, access to top-performing and highly sought-after managers requires a broad network and an institutional brand. Having a strong brand as well as an unbiased and stringent selection process is therefore crucial.
3. Consistent allocation over time. Private equity is a long-term asset class and as such, requires a long-term investment horizon. In order to avoid the risk presented by market timing, investors must consistently allocate to the asset class over time. Investors need to determine their individual allocation plan with consideration for their performance goals, time horizon and expected liquidity needs. A sophisticated bank supports its clients during this planning process.
4. Proper portfolio construction. More often than not, private market investments made by private banking clients resemble a ‘stock picking pattern’, i.e. a selection of opportunistic satellite investments for the liquid/public markets investment portfolio. Institutional investors, however, adopt a holistic view and assure proper diversification across different sectors, managers, geographies and strategies within their private markets portfolios. Private investors should aim for the same. Finally, building up private markets exposure requires time, so investors should focus on products that offer efficient capital deployment and minimise the J-curve.

The Julius Baer private markets platform

While well-judged, cost-efficient, diversified access to private markets was once largely restricted to institutional investors with large portfolios and investment teams, it is becoming more accessible for wealthy private individuals. Clients of Julius Baer can rely on our broad private markets offering – from exposure to high-profile managers for core allocation, to brand names for a satellite approach, pre-IPO deals and custom mandates. This allows them to invest in private markets in a systematic, consistent way, which is completely tailored to their needs and investment goals. Our team of experts also provides a secondary market between potential sellers and buyers, overseeing the entire transaction process.