In uncertain times, private markets show evergreen importance

23 September 2024

After several challenging years, there are signs of life returning to private markets. The $159bn of private equity deals transacted in Q2 was the highest volume in two years, suggesting that the slowdown that has taken hold since the pandemic-era peak may be ending. The record level of uncommitted capital held by private markets funds, now totalling $2.61tn, shows there is no shortage of dry powder with which to fuel the trend in coming quarters.

Still, the market is not exactly in rude health. Exits in the first half of this year were down 26% from the equivalent period in 2023, while a majority of fund General Partners expect valuations to continue falling over the next year. With the economic situation still clouded in uncertainty, these are far from boom times for private markets.

Counterintuitively, that makes it a good time to consider the importance of private markets, which can boast a track record of remaining resilient even when the economy stumbles, and which have a vital role to play both in driving investor returns and innovation for social and economic good. As catalysts for change and cornerstones for value creation, private markets have never been more important – nor has it been more essential for investors to understand their role.

How private markets drive innovation

As a rule of thumb, what ends as a giant and world-changing enterprise usually began as one backed by private market investors. The companies that dominate the stock market with trillion-dollar valuations were, not so long ago, venture-backed startups with funding rounds in the tens of millions. That description applies to seven of the nine listed companies to have joined the trillion-dollar club.

By helping to birth such remarkably successful companies, private market funding acts as an indispensable catalyst for innovation. By their nature, early-stage companies in pioneering fields are highly speculative, risky investments. Many will fail and a few will succeed beyond all hopes. The logic of early-stage investment is that the proceeds of the successes will far outstrip the losses of the failures.

From that philosophy stems a simple and fundamental truth. In transferring risk capital to companies trying to push the boundaries of what is possible, private market funds make innovation possible. They capitalise the idea that emerged from the University science lab, the team of hackers working out of a garage, or the stray moment of inspiration that someone stumbled across.

Historically, the result has been a cohort of companies that are overwhelmingly responsible for investing in and delivering innovation: of non-financial companies that went public in the US between 1995 and 2019, venture-backed firms represented 47% of the total, made up 76% of market capitalization at the end of the period, and had been responsible for 88% of R&D spending.

That propensity for risk and the willingness to finance it is needed now more than ever. Meeting the world’s challenges and maximising megatrends will require unprecedented levels of capital investment: an estimated $3.5tn a year is needed until 2050 to achieve net zero, according to the Energy Transitions Commission, while Goldman Sachs projects that global investment in AI will top £200bn in 2025.

That is investment which no government can come close to providing, and which even public market companies, with the huge scrutiny that accompanies the publication of quarterly results, will struggle in most cases to justify.

It is in private markets, where companies can move rapidly and without having to bring a broad base of shareholders with them, that much of the running toward the future will be made. And with IPOs happening later and later in the company lifecycle, it is by investing in private markets that investors can access the most innovative companies during their most dramatic periods of growth.

How private markets drive returns

As they help to underpin economic progress, private market funds can also demonstrate a robust history of supporting prosperous returns. For investors, private markets represent the best place to make investments in areas of long-term potential. Whether focused on companies in a particular sector, real estate, or infrastructure assets with inflation-protected income, these funds allow investors to gain exposure to the real economy with assets uncorrelated from those already in their portfolios. Their relative illiquidity can also act as a shield against volatility and inflation.

The long-term picture underlines that investors have rarely had cause to regret putting their faith in private markets. On a 20-year outlook, private equity in North America has delivered annual returns of 15.2%, compared to 9.7% for the S&P500. Private funds have offered superior outcomes over the long-term and a degree of protection during downturns: during the global financial crisis of 2007-9, US buyout funds declined 28% from peak to trough compared to 55% for the S&P500.

This outperformance is testament to private equity’s ability to create value, and the many tools at its disposal to achieve this. Investors in private companies can take the long-term view – whether that is restructuring, deploying capex ambitiously or employing leverage – when deciding what is most likely to boost valuation and eventual investment returns.

The advantage of being private is that managers have the mandate to be bold and the capacity to remain patient: ensuring both that the medicine is sufficient and that it is given time to take effect. Whether buying out companies, real estate portfolios or infrastructure assets, private equity funds are always able to focus on long-term value creation. That is the best guarantee of resilient returns in both strong and weak markets.

Is the time right?

The past can never guarantee the future, so the question remains: will private markets continue to act as a bulwark of innovation and investor returns?

Investors may take confidence from the thought that, with their long-term orientation, private market funds are engineered to succeed in a wide variety of market conditions. If rates fall, leverage becomes an attractive approach which can boost returns, while if they do not, higher rates tend to act as a natural governor for the sector, ensuring that scarcer capital is directed towards the best investments.

Private markets are not dependent on macroeconomic conditions for their success: history suggests they can thrive in different weathers because managers adapt, and they use the long runway of patient capital to their advantage. It also shows that the best time to invest is at relatively depressed valuations, nearer the bottom of a cycle than the top.

While the advantages of investing in private markets are enduring, the means are evolving, making these asset classes easier for more people to invest in. The historically opaque and sometimes unaffordable nature of private funds is changing as the rise of semi-liquid structures facilitates greater participation – with streamlined onboarding experiences and regulated digital platforms that aggregate demand to lower investment minimums.

Private market funds are not just one of the most proven vehicles for driving long-term returns; they are also more affordable and accessible than ever before. Even in uncertain times, they offer a degree of reassurance that is hard to find elsewhere. Whatever the economic future may bring, their role in driving growth, innovation and returns will remain evergreen.