ROADNIGHT MUSING – MARCH 2024
PUBLIC VERSUS PRIVATE MARKETS
“Australia has done an unbelievable job in accumulation. But that increase can’t be absorbed in Australia. The choice as to what percentage [the compulsory rate] should be, that belongs to the government. Our choice is to help maximise returns. And public markets are not going to be how people’s return is maximised.”
Marc Rowan, CEO Apollo Global Management
The general perception in finance is that private markets are riskier than public markets. This perception is most evident in rating agencies and regulators’ higher capital requirements for private market investments than public investments.
The difference in treatment is primarily driven by the assumptions that:
Publicly traded securities can be sold when required at their current price (liquidity); and
The market efficiently prices securities.
Thirty years ago, this was broadly true, with private assets — comprising private equity, venture capital, and hedge funds—typified by lower levels of liquidity. In contrast, publicly traded assets were supported by the ability to monetise assets quickly with limited impact on price. However, lived experience raises questions about the validity of these assumptions.
PUBLIC MARKETS TODAY ARE SUBSTANTIALLY LESS LIQUID THAN 20 YEARS AGO
By almost any measure, public markets today are nowhere near as liquid as they previously were. This is a direct consequence of increased financial regulation since 2007 reducing the amount of capital supporting public trading. As a result, market liquidity is 10–25% of market liquidity pre-2007. The impact is that selling an asset in a risk-off environment can cause a substantial price decline (2 – 3 sigma movements in price). This has been clearly witnessed in the bond markets in times of distress when no bids were available for some US government securities. These are extreme movements for risk-free securities, which are the foundation of our financial markets.
Meanwhile, on the other hand, private markets over this time have become a less risky alternative for investors’ dollars and a growing source of diversification in investor portfolios. Why? Very simply, the amount of debt sourced from originators who use leverage (banks) has decreased as a proportion of the total finance provided.
THE RISE OF ETFs AND INDEX-BASED INVESTING HAS CREATED TWO-TIER MARKETS
The composition of equity markets has substantially changed:
Public markets, especially equities, are increasingly concentrated. The S & P 500 currently shows the ‘magnificent 7’ stocks (Microsoft, NVIDIA, Amazon, Meta, Google, Tesla, Apple) make up 33% of the index, and the top 7 Australian stocks make up close to 40% of the index. There is a high level of concentration risk in these stocks alone.
P/E ratios on these stocks (as show in the chart above) are at significant premiums to the long-term median. In the US, a Schiller P/E of 34 (as of March 1) is in the top 1% of history, while profits as a percentage of revenue are also at record levels.
Boring cash-generating companies have increasingly been taken private by private equity. There has been a major shift in the corporate landscape over the past few decades in favour of private markets. The number of private companies globally has grown sharply, and they now outnumber listed ones by almost seven to one [1].
The net result is that public markets have increasingly become focused on growth and future potential, with increased price volatility, while private markets are focused on lower growth boring businesses that generate stable cash flow. Meanwhile, investors seem to have forgotten the 2022 tech correction, when the top 5 US technology stocks fell by 38%, resulting in $3.7 trillion (yes, TRILLION) in losses.
Australia’s equity markets are even more concentrated to the top seven companies, and while these are more dividend yield focused companies, they are nevertheless leveraging the fortunes of investors to Australian banks.
DEBT FUNDING TODAY IS INCREASINGLY EQUITY-FUNDED, REDUCING SYSTEM-LEVEL LEVERAGE AND RISK
In the USA, while the banking system has grown in absolute dollars since the 60s, it has been shrinking as a percentage of total lending. It is roughly 20% of corporate and consumer credit in the US today. Funding for the remaining debt is either sold directly to individuals and institutions or indirectly via funds seeking:
A rate of return for a given level of risk
Investment duration so long as they are obtaining the right risk and reward. That is, they are focused on matching liabilities and assets, not on daily liquidity.
Unlike bank lending, private debt is funded with equity
and no leverage.
As a result, this transfer of debt exposure from the banking system levered at 8-10 times (which before the 2007 was 10–18x) to the private debt markets has:
De-levering the overall system due to private debt funders having zero leverage, and
Provided investors with the opportunity to gain exposure to assets they typically could not access, diversifying their portfolios (and potentially lowering their risk)
Australia has been following this trend in the USA for some time now. However, like the concentration in Australia’s equity market, the domestic corporate bond universe is dominated by Australia’s banks as borrowers, making our fixed income market even more highly concentrated.
As an investor, you now have the choice between:
Government-backed, borrow-short-lend-long banking system accessed through the public markets; or
Invest in private debt through the private markets.
Credit risk can be similar, but there is less liquidity in the private market. Conversely, the banking system is levered 8-10 times and trades at a 3-year average P/E ratio of 15.0 times. The four major banks in Australia represent 20% of the ASX and are typically a significant proportion of most investors’ portfolios.
SO WHAT DOES THIS MEAN, AND HOW DOES PRIVATE CREDIT FIT IN?
BlackRock’s global investment strategist recently warned that the world has shifted from a period of low inflation, low-interest rates and low geopolitical tension to “great moderation” – a new regime typified by higher inflation, higher rates and greater geopolitical tension. That will make for a more volatile world, where the easy market gains of the post GFC period will fade, and a much more selective approach to investing will be required [2].
Given the growing volumes of bank-grade credit being originated and managed in the Private Markets by fund managers, investors are presented with the opportunity to obtain access to assets previously unavailable.
By partnering with an experienced Private Debt fund manager, investors can access strong risk-adjusted returns to low volatility assets with low correlation to other asset classes like equities and property. Private Markets will increasingly be the key to maximising returns in an investor’s overall portfolio.
[1] Barclays, “Trends in private Markets” November 2021
[2] Thomson, James, “The two tectonic shifts in markets that will decide the next decade”, The Australian Financial Review, March 2024