Morningstar: What the public-private convergence means for advisers – Portfolio Adviser

By Nicolo Bragazza, associate portfolio manager at Morningstar Wealth

The convergence of public and private markets is a growing trend as a larger number of end investors gain access to a broader range of historically private opportunities and asset classes.

When we talk about private investments, we usually refer to investments that are only available to institutional investors and they are often offered through partnership structures with limited liquidity and infrequent pricing. This means that investing in private markets requires a long-term commitment and accepting a certain degree of opacity over the actual value of the underlying investments. 

Although the inclusion of private assets in investors’ portfolios is nothing new, the increased availability of data, products and regulatory changes have radically changed the landscape and are prompting more people to consider whether an allocation to private assets or funds is appropriate for their clients’ portfolios.

As this convergence gathers pace, it is essential that advisers and investors have access to reliable information and data so that they can balance risk and opportunities appropriately.  

How will it impact portfolios?  

There are two main ways of thinking about the public-private market convergence in the context of investors’ portfolios: the first is including private assets and funds within investors’ allocation to unlock different sources of returns and potentially increasing diversification.

The second is via bringing more liquidity and increasing the frequency of pricing and redemptions to private markets and assets.

The first approach is nothing new from an investment management perspective. David Swensen pioneered this approach within the Yale endowment and other university endowments have since gone down the same route of investing heavily in alternatives, including close-end funds.

See also: How are retail investors benefiting from private markets?

The idea was simple, although was not widely implemented at that time. The longer the time horizon, the easier for investors to accept locking their money into closed-end funds to extract additional returns through exposure to an illiquidity premium and via an expanded investable universe.

In this case, the theoretically infinite time horizon of an endowment, coupled with its predictable yearly cash outlays, provided the perfect environment for this new investment model of blending public and private investments to achieve higher long-term returns.

However, the use of these investments within investors’ portfolios has always been very limited due to the liquidity mismatches that may arise when time horizons differ, as cash needs may require early redemptions. Additionally, less sophisticated investors may lack the ability to navigate through the complexities, including legal and financial, and the opacity of private investments.  

The second is the creation of investment vehicles that give access to private assets whilst allowing for more frequent liquidity and pricing, which is perhaps one of the most promising ways of bringing private markets into investors’ portfolio, although this is not without risks.

See also: Private markets: Wealth managers face high barriers to entry

In this regard, one of the most ambitious approaches in making illiquid assets more liquid can be found in the application to the SEC made by Apollo and State Street for an ETF investing in private credit. In the UK, the recently introduced LTAF (Long Term Asset Fund) constitutes a development of the idea of public-private convergence as these funds can invest in illiquid assets whilst allowing investors to redeem or to subscribe more frequently.

The regulatory framework for the LTAF has been designed to allow more investors to invest in illiquid assets, supported by additional rules around notice period, frequency of redemptions and borrowing in an effort to mitigate the risk of mismatches between the liquidity of the fund and that of the underlying assets.

Although they do not completely solve the issues of more infrequent pricing and valuation of private investments, the LTAF should open new opportunities and can potentially help investors in achieving better long-term returns. 

Will it bring higher returns for the end investor?  

The convergence could potentially deliver higher returns, but outcomes will need to be evaluated against the additional risks that private investments bring.

Author John Kenneth Galbraith noted in his book ‘A Short History of Financial Euphoria’ how financial innovation, especially when it is not based on fundamental differences, may hide some risks and, historically, this has been behind some of the most famous periods of euphoria which ultimately didn’t bring much benefit to investors.  

Theoretically, the addition of more and new assets should push the ‘efficient frontier’ upward, which means that for any given level of risk, investors should be able to generate higher returns.

See also: Bain & Company: Private markets to make up 30% of AUM by 2032

The convergence between private and public represents a significant expansion of the investable universe, now encompassing private companies and private debt, and all else equal, this means that the skilled investor has more tools to generate alpha.

However, the nature of the investment needs to be properly evaluated and understood. Within the idea of bringing liquidity to illiquid assets, there is the potential risk that liquidity may only be a feature in stable and improving market conditions, whilst it may quickly disappear at the first sign of stress.

Additionally, if liquidity is enhanced, this may significantly reduce the illiquidity premium, thereby causing a convergence toward public investments’ returns.  

Advisers will play a key role in navigating growing convergence  

The public-private convergence might offer a new opportunity for investors to improve the risk and return profile of their portfolios and to align them with their time horizon more appropriately.

The availability of new products and the attention of regulators around this development should help in ensuring that investors can have more available choices for their investment needs.

Given the additional complexity and potential risks of these investments, advisers play a very important role in ensuring clients make informed financial decisions and should keep a close eye on any developments on this front.