Liquidity issues affecting private markets

Although the US Federal Reserve and other central banks are now cutting interest rates, the post-COVID hiking cycle continues to affect private markets. First COVID and then tighter financial conditions, along with uncertainty and volatility, limited the appetite of strategic and financial buyers and the ability to IPO businesses. Earlier-vintage buyout, venture capital, and real estate funds were limited in their ability to monetize investments and book realized gains.  

According to a March 2024 Bain & Co. report cited by the Financial Times, private equity managers are sitting on a record 28,000 unsold companies worth more than US$3 trillion. Industry DPIs (distributions to paid-in capital; see chart) are now well below 1.0x and many limited partners do not have the dry powder to allocate to new funds, severely affecting fundraising. This lack of flexibility to allocate to new funds may be to their detriment, as we believe the combination of an economic soft landing, lower interest rates, and easy borrowing conditions will drive animal spirits in the private markets, leading to increased deal flow and returns. 

_{Source: PitchBook, as of October 2024. *As of September 30, 2023. DPI, or distribution to paid-in, is a performance metric used in private equity to measure the amount of capital that has been returned.} 

Part of the market response to slow distributions has been increased interest in private credit and secondaries, with the common thread being liquidity management.  

In private credit, the buoyant demand we are witnessing in the public markets is multiples greater in the private markets. Part of the demand is the result of annuities being sold at a pace three times that of 2021. As well, high overnight interest rates, elevated spreads and an extended period of an inverted or flat yield curve have made private credit particularly compelling. Also contributing could be the expectation that private credit, where underlying investments are usually short in duration (e.g., one-year secured loans), could help mitigate fund life-cycle liquidity issues. 

Secondary transactions, which are typically done at a material discount to NAV (i.e., an illiquidity premium on top of the asset class’s illiquidity premium), provide sellers with liquidity to rebalance portfolios and buyers with vested private equity exposure and the expectation of near-term distributions, since the underlying investments are closer to the end of their life cycle than those made in newer vintages.  

It is easy to understand the attraction of adding private market assets to portfolios for return-seeking and volatility-dampening reasons. As asset-liability matching permits, investors can harvest the illiquidity premia offered by private markets. What conclusions, though, can we draw from the growth of private credit and secondaries and this new focus on DPI? Perhaps general partners could not envision how a high-volatility, high-borrowing-cost environment would affect monetizations. Perhaps liquidity is consistently undervalued until it is needed. Perhaps portfolio construction approaches to private market assets were flawed to start.  

Optimization can be run for return-seeking, volatility-dampening, or for liquidity management. Alternatively, optimization can be run to accommodate all three goals, with an additional liquidity lift coming from vintage diversification. Holding private credit, for example, alongside private equity and venture capital can provide the liquidity to be able to remain agile and tactical. Our analysis suggests that a portfolio optimized for returns, volatility, and liquidity comprising allocations across the private market segments can lift the information ratio when added to client balanced portfolios. 

Using MSCI US private markets index data from 2005 to Q3/24, a 20 percent allocation to a growth-focused private markets portfolio with a strategic asset allocation of 30 percent private equity, 20 percent private credit, 20 percent real estate, and 10 percent each to infrastructure, venture capital, and the S&P 500 (via SPY) lifts a global balanced portfolio’s historical returns by 30 bps to 7.4 percent, lowers volatility by 170 bps to 5.7 percent, and therefore lifts the information ratio from one to 1.3. Liquidity is also a function of performance behavior relative to other parts of the market. This strategy has correlation coefficients of 0.2 to the Russell 1000 Index and -0.2 to the Bloomberg US Aggregate Index. 

Investors should always be aiming to solve for the right outcomes with the right exposures. The significant increase in private credit and secondaries interest suggests that liquidity, and the flexibility it affords, have been underappreciated. A diminished ability in private markets to rebalance exposures makes portfolio construction incredibly important. Greater performance disparity across managers in the private markets than in the public markets and the higher persistence of outperformance makes manager selection likewise incredibly important. Scale, experience, and resources are required to get both right, and plans and endowments should consider multi-manager, multi-strategy, multi-vintage fund-of-fund solutions. 

Marc-André Lewis is president and chief investment officer and Geof Marshall is senior vice president, head of fixed income and lead – private markets for CI Global Asset Management.