A private revolution is upon us

There’s been a private revolution happening in the financial markets.

While the media is captivated by the latest gyrations in digital currencies, longstanding traditions are being upended elsewhere. For years, there have been investment strategies that were only used by institutions and the ultra-wealthy. Now, these strategies are being used by everyday investors.

Among the most popular of these “institutional” strategies are those that tap into the private debt and equity markets. Historically, these strategies have offered compelling returns and income, so it’s fair to ask, are they worth their risks? How important could they be to achieving your retirement goals?

The road to revolution

A more basic question needs to be answered first: Why are these private market strategies becoming more widely used? The simplest answer is companies need the money.

The global financial crisis in 2008 spawned more regulation and that restricted traditional bank lending and forced small- and medium-sized companies to seek capital from “nonbanks,” such as investment firms. The debt and equity these firms raise for capital are not traded in the public markets, and with the expanded need for capital came a need for an expanded investor base.

And expand it did. The private equity market has surpassed $5 trillion while private debt stands at around $2 trillion as an asset class and is growing fast, according to industry estimates.

Unique leadership

It’s not surprising that this asset growth is being driven by the potential for attractive returns, but private debt and equity provide them with interesting twists.  

The yields of private corporate debt historically have been well above those offered by publicly traded bonds. A lot of this private debt comes in the form of floating rate obligations. Unlike traditional bonds that have a fixed rate, yields of floating rate obligations are able to adjust with current market yields. This means their returns are less sensitive to interest rate changes.

That’s a good thing if you recall the bond market rout in 2022. Less interest rate sensitivity can diversify a traditional bond allocation and help with overall portfolio stability.

Private equity also has its attributes. Equity funds may invest in small- to medium-sized firms with a long runway of potential growth and needed operational efficiencies, so these stakes can appreciate nicely over time. Like private debt, private equity shares can increase portfolio diversification as their values don’t trade in tandem with the prices of publicly traded stocks.

Diversification and the potential for attractive returns. What’s not to like?

Keep in mind that typically you only get these equity returns once the company is sold, goes public or is recapitalized. That can take more than a decade, which brings us to the risks.

What revolution is perfect?

With the opportunity for greater returns comes greater risk, so these strategies are not appropriate for all investors. Individual investors can seek access to private debt and equity funds through their financial planner. Planners can help ensure that the investments are appropriate for the investor’s goals and risk tolerance. In the case of most private equity funds, for example, investors need to meet certain asset or income qualifications. Let’s mention two major risks that these strategies have:

1. Liquidity risk
   
   The biggest risk can be limited liquidity. Because these funds represent private ownership and their shares aren’t traded in an active pool of ready buyers and sellers, you can’t immediately sell out of the funds. That can mean redemptions are only allowed once a quarter and for some funds, you must wait much longer than that.
   
   Investors need to have enough cash on hand to rely on in the interim. 
   
   When there are periods of market tumult, and it’s inevitable that there will be, it can be particularly hard to find buyers and sellers. Redemptions could take even longer, and you may not be able to redeem all the shares you want at once.
   
   
2. Leverage
   
   A number of these funds borrow money to boost potential returns with the aim of profiting more than the cost of borrowing. Leverage is a sophisticated strategy that can amplify returns both up and down, but it can also result in larger capital losses as well as gains.

Our approach

We believe that when investing in private equity and debt, you should seek a fund that has reasonable redemption restrictions (for instance, quarterly) and competitive fees. Remember that fees only take away from your returns. Understand how the fund uses leverage and the investment risk it presents.

Just as importantly, make sure the fund is diversified.

One of the primary attributes of a private credit or equity fund is its potential to increase overall portfolio stability by being a diversifier, so you want the fund itself to benefit from diversification as well. We would look for funds that diversify across many companies, sectors and geographies.  

Do I need to be a revolutionary to achieve my retirement goals?  

The short answer is “no.”  Historically, a well-diversified portfolio of stocks and bonds has helped people achieve their retirement goals and we don’t expect that to change. That said, for a number of investors, it could be worth exploring how a private equity and/or debt fund can fit into your financial plan.

If you’re curious, talk to your financial planner to determine if these funds could make sense given your financial circumstances and goals.