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What are private investments?
“Private investments” is a catch-all term referring to financial assets that do not trade on public stock, bond or derivatives markets. They include private equity, private debt, private real estate pools, venture capital, infrastructure and alternative strategies (a.k.a. hedge funds). Until recently, you had to be an accredited investor, with a certain net worth and income level, for an asset manager or third-party advisor to sell you private investments. For their part, private asset managers typically demanded minimum investments and lock-in periods that deterred all but the rich. But a 2019 rule change that permitted “liquid alternative” mutual funds and other innovations in Canada made private investments accessible to a wider spectrum of investors.
Why are people talking about private assets?
The number of investors and the money they have to invest has increased over the years, but the size of the public markets has not kept pace. The number of operating companies (not including exchange-traded funds, or ETFs) trading on the Toronto Stock Exchange actually declined to 712 at the end of 2023 from around 1,200 at the turn of the millennium. The same phenomenon has been noted in most developed markets. U.S. listings have fallen from 8,000 in the late 1990s to approximately 4,300 today. Logically that would make the price of public securities go up, which may have happened. But something else did, too.
Beginning 30 years ago, big institutional investors such as pension funds, sovereign wealth funds and university endowments started allocating money to private investments instead. On the other side of the table, all manner of investment companies sprang up to package and sell private investments—for example, private equity firms that specialize in buying companies from their founders or on the public markets, making them more profitable, then selling them seven or 10 years later for double or triple the price. The flow of money into private equity has grown 10 times over since the global financial crisis of 2008.
In the past, companies that needed more capital to grow often had to go public; now, they have the option of staying private, backed by private investors. Many prefer to do so, to avoid the cumbersome and expensive reporting requirements of public companies and the pressure to please shareholders quarter after quarter. So, public companies represent a smaller share of the economy than in the past.
Raising the urgency, stocks and bonds have become more positively correlated in recent years; in an almost unprecedented event, both asset classes fell in tandem in 2022. Not just pension funds but small investors, too, now worry that they must get exposure to private markets or be left behind.
What can private investments add to my portfolio?
There are two main reasons why investors might want private investments in their portfolio:
- Diversification benefits: Private investments are considered a different asset class than publicly traded securities. Private investments’ returns are not strongly correlated to either the stock or bond market. As such, they help diversify a portfolio and smooth out its ups and downs.
- Superior returns: According to Bain & Company, private equity has outperformed public equity over each of the past three decades. But findings like this are debatable, not just because Bain itself is a private equity firm but because there are no broad indices measuring the performance of private assets—the evidence is little more than anecdotal—and their track record is short. Some academic studies have concluded that part or all of private investments’ perceived superior performance can be attributed to long holding periods, which is a proven strategy in almost any asset class. Because of their illiquidity, investors must hold them for seven years or more (depending on the investment type).
What are the drawbacks of private investments?
Though the barriers to private asset investing have come down somewhat, investors still have to contend with:
- lliquidity: Traditional private investment funds require a minimum investment period, typically seven to 12 years. Even “evergreen” funds that keep reinvesting (rather than winding down after 10 to 15 years) have restrictions around redemptions, such as how often you can redeem and how much notice you must give.
- Less regulatory oversight: Private funds are exempt from many of the disclosure requirements of public securities. Having name-brand asset managers can provide some reassurance, but they often charge the highest fees.
- Short track records: Relatively new asset types—such as private mortgages and private corporate loans—have a limited history and small sample sizes, making due diligence harder compared to researching the stock and bond markets.
- May not qualify for registered accounts: You can’t hold some kinds of private company shares or general partnership units in a registered retirement savings plan (RRSP), for example.
- High management fees: Another reason why private investments are proliferating: as discount brokerages, indexing and ETFs drive down costs in traditional asset classes, private investments represent a market where the investment industry can still make fat fees. The hedge fund standard is “two and 20”—a management fee of 2% of assets per year plus 20% of gains over a certain threshold. Even their “liquid alt” cousins in Canada charge 1.25% for management and a 15.7% performance fee on average. Asset managers thus have an interest in packaging and promoting more private asset offerings.
How can retail investors buy private investments?
To invest in private investment funds the conventional way, you still have to be an accredited investor—which in Canada means having $1 million in financial assets (minus liabilities), $5 million in total net worth or $200,000 in pre-tax income in each of the past two years ($300,000 for a couple). But for investors of lesser means, there is a growing array of workarounds:
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Michael McCullough
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