Private Markets and Implications for Portfolios

What drives the transformation of private markets? How to effectively manage portfolios focused on this sector? According to PGIM experts, there are four factors for each question (the result of research involving the insights of over 40 investment professionals, including managers of private alternative, real estate, bond, and equity strategies, as well as prominent academics, investors, and sell-side researchers).

Here are the four factors guiding the transformation:

  1. High-risk loans shift away from traditional financing methods: Over the past 20 years, regulatory changes and shifts in the business model have led banks and various financial companies to distance themselves from riskier segments of corporate and real estate loans. According to the Federal Reserve (FED), the share of banks offering corporate financing was close to 70% in 1980, but by 2020, it failed to reach 40%.
  2. Private markets attract income and yield-seeking investors: In recent years, investors have had to broaden their horizons to find assets capable of delivering income and attractive returns. Currently, the median allocation of private market assets for the top 10 institutional investors is 23%. According to the FED, the allocation of U.S. pension funds to real estate and private equity was 20% in 2021, compared to 8% two decades earlier.
  3. Increasingly, business models are suitable for private markets: Some companies may be better appreciated and financed through private markets, such as those based on intangible assets like proprietary software or other intellectual properties. Conventional fossil fuel companies are also turning to private capital markets as some ESG-sensitive investors have excluded this sector from their investment portfolios.
  4. Companies remain private longer: The median age of companies at the time of listing has more than doubled in the last twenty years, reaching 11 years. This evolution is driven by the growing availability of private capital in various financing stages and the burdensome nature of information and the costs of going public, especially in developed markets.

Here are four implications for portfolios:

  1. Public and private markets have increasingly blurred boundaries, requiring more flexible approaches: The once-clear distinction between syndicated loans and private markets is becoming less evident. Consequently, the formerly distinct boundaries between public and private market investment teams at institutional investors are becoming increasingly blurred.
  2. Liquidity risk needs a more sophisticated approach: A comprehensive portfolio structure, including multiple time horizons, can be used for stress testing and building models for different market scenarios. These results can be compared with public market assets to gain a deeper understanding of the liquidity characteristics of the private alternative portfolio.
  3. The influence of ESG factors on private markets is recent but expected to increase: While it's a common belief that ESG issues are less important in private markets compared to public markets, private market investors play an increasingly significant role in emphasizing the need for more detailed ESG criteria reporting.
  4. Private investors can enter private markets with long-term defined contribution plans: There is a growing focus on creating responsible pathways for retail investors to participate in opportunities available in private markets, especially in defined contribution plans with a long-term investment horizon, potentially aligning well with the longer lock-up periods of private assets. However, there are significant challenges to widespread implementation in these plans.

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