For high-net-worth families, private investments present an attractive opportunity to find value, generate alpha and enhance the diversification of their portfolios, and survey after survey suggests that family offices are increasing their exposures to private markets.
As the Capgemini Research Institute noted in its World Wealth Report 2024, “a desire to diversify into high-return asset classes is driving increased HNWI interest in alternative investments—including commodities, currencies, private equity, hedge funds, structured products, and digital assets.” A recent global survey from Bastiat Partners and Kharis Capital found that 40 per cent of family offices plan to increase their private equity holdings over the next two years—more than any other asset class.
But private markets aren’t always friendly to investors, and they come with added risk, requiring increased due diligence, choosing advisors more carefully, and pulling off a delicate balancing act between seeking higher returns and sacrificing liquidity.
What’s driving the reallocation?
Part of the reason for increased interest in private markets is the expectation of more normalized—that is, lower—long-term returns in public markets. A Goldman Sachs portfolio strategy investment report on Oct. 18 estimates that “the S&P 500 will deliver an annualized nominal total return of 3% during the next 10 years.”
“Admittedly, they’re a bit conservative,” says Ash Lawrence, head of AGF Capital Partners, AGF Management Ltd.’s diversified alternative business, of the Goldman Sachs estimate. “But if public equities over the next 10 years are headed for a more moderated return environment, the context we’re hearing from both retail, high-net-worth individuals and family offices is that if they haven’t already put a portion of their assets into alternatives, they are now actively thinking about it again.”
The falling interest rate environment of the past several months is one of the factors driving investors to private equity, says Paul de Sousa, head of wealth management, sales and development at Sightline Wealth Management, an independent wealth management firm specializing in alternative investment strategies.
“As we’ve seen rates fall over the last year, there’s a search for higher returns and diversification,” de Sousa says. “But we’re also seeing an increased familiarity with alternative investments, which I believe are becoming more mainstream for individuals and families with higher net worth. They’re looking at Canadian pension funds, then looking at their allocations and using that as a model.”
Private markets are perhaps seen as more exciting and exotic because they’re not accessible to everybody
Dan Hallett
Some wealthy investors have become disillusioned with public equities, particularly in the U.S., says Dan Hallett, vice-president, research & principal, Highview Financial Group, an independent fiduciary portfolio manager. That’s because the majority of returns over the past year has been driven by a small number of tech stocks with high valuation multiples.
And some of the reasons for embracing private investment may also be personal.
“A lot of these families built their wealth in private business,” Hallett says. “It’s an area with which they have some familiarity. And I think part of it is that stock and bonds can seem somewhat ordinary and common. Private markets are perhaps seen as more exciting and exotic because they’re not as accessible to everybody.”
As companies shift to private, so do investors
Wealthy investors may also be following the shift of companies out of the public realm into private financing.
According to a May 2024 report, The Growth of Private Financial Markets, published by the U.S. Political Economy Research Institute, issuances of public equity raised US$139.1 billion in 2023. That same year, private markets raised US$1.32 trillion, outpacing the public market by 10 to one.
Lawrence notes that increased regulatory burdens following the great financial crisis, however justified, are part of the reason for the shift.
“There’s a higher cost to accessing capital financing in public markets that is hindering smaller companies and making a bigger impact on their P&Ls,” he says. “Now that private markets have grown in terms of opportunity, their options have increased to get that financing when they’re likely going through their value creation stage.”
Lawrence says the trend of “shrinking public markets” in the U.S., UK and Canada has seen listed public companies decrease in number by between 30 and 50 per cent over the past 20 years, as more companies opt for private capital financing. In the U.S., he says, 90 per cent of companies with US$100 million or more in revenue are now private. And companies are remaining private for longer: two decades ago, the average time to a public offering was three or four years; today, it is eight or nine.
“For investors to really get the broad universe of opportunity around those companies, whether it’s equity or credit financing, you now really need to be in the private space in one form or another,” Lawrence says.
How much private equity is too much?
Yet the potential for increased returns in the private space is also counterbalanced by increased risk.
“It’s not as though the risk in public markets is zero, but fraud risk in private markets is higher than in public markets,” Hallett says. “The required disclosure just isn’t as robust, and you have to ask more questions, know what to ask for, and do more investigation.”
For investors, deciding how much of their portfolio should be allocated to private markets is a strategic choice, but also a practical one.
“We stress that these are illiquid investments,” de Sousa says. “We do quite a bit of work up front in determining the right allocation if you assume, under a worst-case scenario, that 10 to 20 per cent of your portfolio will not be accessible for a longer term.”
Hallett agrees, noting that he counsels clients to keep most of their portfolio allocation in public or traditional markets.
“If you put 70 per cent of your assets in private markets, you’re not always being compensated for that illiquidity,” he says. “And the more you have tied up in illiquid investments, the less flexibility you have to rebalance your portfolio.”
Lawrence also looks at private investment allocation conservatively, with an average allocation of 10 per cent for most advisors and around five per cent for advisors investing on behalf of clients with smaller portfolios.
“For family offices, maybe a little more—on average 10 to 25 per cent,” he says. “In no way are we suggesting advisors take the CPP [Canada Pension Plan] approach and put half their assets into alternatives.”
Manager selection might matter more
Investing in private equity requires a seasoned manager. Even investors who have experienced some success in self-managing their public equity portfolios may find their skills aren’t transferable.
“You may assume that you can take what you’ve done in traditional markets and start doing it in private markets,” Hallett says. “I think that’s naive and maybe a bit dangerous. As robust as your due diligence process may be, at the end of the day you’re still an outsider.”
De Sousa notes that it’s essential for private equity managers to demonstrate an alignment of interests with investors.
“They need to have some skin in the game, and invest their own capital alongside the investor,” he says.
The private equity space is far from monolithic, so he suggests that investors may also need to seek out managers who can bring sectoral experience to the table.
“In a desire to achieve diversification, investors seek out private assets they believe have a low to negative correlation with public markets,” he says. “That’s not always the case. You could have private equity in the technology space, which would be quite closely correlated to the NASDAQ, because it’s still technology. You want to ensure the manager has a deep expertise in that sector and is someone who can assess the team’s track record in scaling technology companies.”
With rates near zero and pretty aggressive flows of capital, it was pretty heard for a private equity firm to not do well
Ash Lawrence
The good news is that there are plenty of private equity managers available to investors. The not-so-good news? Not all of them are equally skilled.
“Over the last 10 years, the huge explosion in private markets directed a lot of money to private equity, creating a boom in the number of private equity managers,” Lawrence says. “In an economic environment with rates at or near zero and pretty aggressive flows of capital, it was pretty hard for a private equity firm to not do well.”
In more challenging times, however, the game could change. Lawrence notes that private equity investment strategies traditionally involved buying companies that were either poorly run or undervalued, then improving operations, mining efficiencies, accessing new markets, and executing on business strategies to create real value and generate returns.
“For the next 10 years, I think we’ll see a return to the basics,” he says, “where investors really need to pay attention to the managers’ skill set in value creation.”
Finding room to grow in private credit
On the large cap front, private credit markets are becoming congested, Lawrence says. Over the past 18 to 24 months, large cap companies have borrowed heavily to fund transactions like private M&A deals, and private lenders have filled the debt gap created after last year’s regional banking crisis shut down much of the lending in that space from U.S. banks. Now, however, bank lenders have returned, and they’re fighting to regain market share. The crowded market for the same deals is driving down returns.
“On the institutional side, we’re starting to see some of the more knowledgeable investors become a little more selective on where they want to play in private debt as large cap credit markets become more competitive,” Lawrence says. “We’re big fans of the mid-market and lower-mid market where competitive dynamics are more beneficial to investors. We like Canadian credit strategies as well. There’s just less competition here.”
The private credit space offers a surfeit of managers who performed well in an environment marked by cheap money and few defaults, he adds.“You could put money out and the money and returns would come back,” Lawrence says.
“With higher rates, investors should ask themselves how that manager will work with borrowers who are under stress. Can they preserve their capital as a lender or maximize repayments with borrowers, restructure debt or work out debt? Make sure your manager has those skill sets.”
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