Advisory practices of all types have been growing steadily over the past several decades through applying various practice approaches and structures that emphasize their fiduciary responsibility to act in the best interest of the client. As fiduciaries, most advisors have utilized primarily or even exclusively public market securities such as individual stocks and bonds, mutual funds and exchange traded funds (ETFs) to deliver their professional investment services.
More recently, the growth of alternative investments in sectors ranging from private equity to real assets to hedge funds have offered both challenges to fee only advisors and new opportunities. Unfortunately, in many cases, the structures of these alternative investments and their lack of updated pricing have made it difficult or impossible for fee-based advisors to provide them to their clients. Yet, potentially attractive performance attributes and increasingly attractive and flexible structures are creating growing possibilities for advisors to provide their clients access to these unique investments.
The value creation stage is changing
As important as structure, a fundamental shift in capital formation outside of public markets creates almost an imperative for advisors to broaden their services to clients to including exposure to these investments. The dramatic shift in the process by which growing companies secure financing provides a clear illustration.
Seemingly regardless of size, companies no longer need to access public markets to secure growth capital, and companies are waiting longer to list their shares on public markets. The average age of listing companies had grown to about 18 years old by 2017 versus only 12 in 1996.[i] Firms are also waiting to reach much later stages of growth before accessing public markets.
For example, Microsoft listed in 1986 providing investors in their public stock greater returns than those earned by the original investors before going public.[ii] Amazon followed a similar pattern of listing early in their development. The firm originally listed as a small-cap stock in 1997 at a market value of $438 million allowing individual investors to participate in its phenomenal growth to nearly a $1 trillion firm today.[iii]
Compare these companies to Google. The firm went public on August 19, 2004, becoming the largest initial public offering in history by raising $1.6 billion at a valuation of $23 billion. Through January of 2018, investors in Google’s public stock would have earned $22,000 for every $1,000 invested on the day of the IPO. Yet, if the same investor had invested originally in Google as a young, private start-up company, the same $1,000 would have grown to $1.1 million.[iv]
Similar examples are common and multiplying. Twitter listed at around a $24 billion valuation and Snapchat’s IPO put their valuation at $29 billion. Uber, a company less than 10 years old, remains private and has an estimated valuation above $70 billion. Another private company, Airbnb, expects to list at more than a $30 billion valuation. Investors in only public markets are missing out on returns that today go to private market investors.
As public markets decline, where does that leave your clients?
The changes in private funding have not only impacted private markets; they are dramatically impacting public equities. Since 1996, the number of public companies trading in the U.S. has dropped by more than half from more than 7,400 companies to less than 3,700.[v] Today, there are fewer public companies in existence than there were in 1976 despite a more than tripling in the U.S. GDP over the same time period.[vi]
Multiple reasons for the decline exist including increased regulation, higher listing fees, dramatically higher disclosure requirements, potential risk of activist investors and seemingly countless areas of greater legal liability. At the same time, the perceived benefits of going public have also declined, largely because capital markets have evolved to provide funding at various stages of growth, often more cheaply and easily than through a public listing.
Not surprisingly, larger and more sophisticated investors such as endowments, sovereign wealth funds, pension funds and family offices are increasingly focusing on private investments in the belief that the sector will add alpha to their portfolios. Their sentiments were noted by a 2018 McKinsey & Company report that stated, “90 percent of LPs [pension funds] said recently that private equity (PE), the largest private asset class, will continue to outperform public markets.”[vii]
The evolution of capital markets presents significant challenges and potential opportunities for advisors and their clients. If more value creation is shifting to private markets, investors without these types of investments in their portfolios are missing the unique investment performance and characteristics available in private markets. In addition, concentration within various public market sectors has increased because of far fewer traded companies given the size of the U.S. economy. As concentration rises so does risk, making access to diversification opportunities potentially offered through private investments particularly attractive.
Private markets provide more, better investment opportunities
While the growth of private markets at the expense of public markets can be clearly seen within equity markets, similar trends are appearing within other sectors as well. In the real estate sector, endowments and institutions have invested directly for many decades, utilizing their size and sophistication to bypass public markets. The large institutions have sought investments with less correlation and dependence on public markets as a means to diversify their portfolios. As the trend has continued, private markets within this space have grown increasingly large and sophisticated, providing many larger investors access to the asset class outside of public markets. Again, this has often left individual investors with only publicly traded REITs as the means to access real estate. Unfortunately, traded REITs tend to suffer from much higher volatility than the underlying assets and greater correlation with publicly traded equity assets.[viii]
In another sector, private credit and lending markets have exploded in recent years as banking regulatory changes forced many companies to use funding sources other than banks. The result has been an explosion of capital raised via private markets, offering savvier investors unique investment opportunities. Oil and gas and various other investment sectors have all experienced a dramatic rise in private market funding.
As private markets have grown, the financial services industry has been creating more ways for more diverse investors to access these types of investments. The growing size of the private markets has attracted increasingly larger and more sophisticated firms, including various large entities that have historically worked primarily with institutions. As the market has grown in size and sophistication, structures continue to evolve to attract funds from a wider pool of advisors. As a result, advisors have a broad and growing array of choices to access various private markets, including private equity, real estate, private credit, oil and gas, hedge funds and more. More recently, broad access to these investments have moved beyond only accredited investors, often through the use of interval fund or mutual fund vehicles.
Without private investments, are you meeting your fiduciary duty?
As private markets expand, advisors seeking to best serve their clients seem well-advised to identify attractive structures and approaches to provide their clients access to rapidly expanding investment opportunities. Private markets can offer potentially both desirable performance characteristics and diversification benefits that are simply unavailable via traditional public markets. Moreover, advisors who fail to adapt to the changing investment conditions could be seen as falling short of their fiduciary requirements. Excluding private markets in portfolios prevents clients from enjoying the benefits of new sectors and structures that larger investors embraced long ago. Finally, the decline of public markets as a percentage of GDP likely raises the risk to investors of greater industry concentration and potentially higher volatility. Constructing and managing portfolios using only public market tools and vehicles appears increasingly outdated as financial markets rapidly evolve and increasing numbers of investors take advantage of multiple new opportunities.
Daniel Wildermuth is portfolio manager for the Wildermuth Endowment Fund and has over 25 years of investment experience. He has been a pioneer in adapting the endowment investment approach to the needs of individual investors. Mr. Wildermuth is also CEO of Kalos Capital Inc., a broker-dealer with over $2 billion in client assets and over 100 advisers; and Kalos Management Inc., a money management firm that administers more than 20 equity and fixed income portfolio strategies for retail and institutional investors.
vii. McKinsey & Company, “The Rise and Rise of Private Markets”, McKinsey Global Private Markets Review 2018, p. 3.