Who participates in private markets?

To date, most individuals would have found it difficult to invest into unlisted assets directly. They have done so via their retirement funds, which are governed by the Pension Funds Act. Regulation 28 of the Act allows these funds to invest in unlisted assets, which gives their underlying investors exposure to types of assets and cashflows which they cannot achieve in public markets.

Private markets give institutional investors exposure to stable cashflows backed by real assets whose value does not rise and fall every day with the moods of the market. Private assets also tend to be less vulnerable to inflationary pressures than more traditional listed assets.

Private markets therefore have an important role to play in a diversified portfolio but are a demanding asset class. Investors should only access them using an accredited, institutional quality manager.

Recent changes to Regulation 28 have raised pension funds’ maximum allocation to offshore assets and clarified their ability to invest in alternative investments such as private equity, debt, or hedge funds. Importantly, these changes mean that pension funds can now invest in a broad spectrum of infrastructure assets. This is a major step forward in the development of the infrastructure assets that SA desperately needs, especially in areas such as renewable energy, desalination, the digital economy, water, sanitation, and roads.

The South African government may be fiscally constrained but the country’s retirement, pension and provident funds together manage more than R5 trillion of assets and are constantly seeking new investment opportunities. This deep pool of capital is not limited only to funding the next generation of SA’s public infrastructure, but also applies the discipline, transparency, governance, and accountability that private sector investors demand and the public sector sometimes struggles to deliver.

Hand-in-hand: private equity & private Debt

Broadly speaking, companies and projects raise two types of private market capital: debt and equity. Debt is a lower risk investment, since it is capital that must be repaid on a contractual basis. Equity is risky for investors but also essential to the raising of debt. Lenders require a layer of shareholder capital as their margin of safety. Private equity and private debt are both essential to the development of the capital-intensive infrastructure and private assets that SA needs. Of the two asset classes, debt represents a lower-risk entry point for investors who may be considering an exposure to unlisted assets for the first time.

Private markets solve problems for Issuers

Stock market investors expect companies that are listing for the first time to be established businesses which are seeking capital for growth. Projects and businesses which are capital-intensive from the start require an investor mindset which is foreign to listed markets. If you wish to build a solar farm or a biomass power plant, you must raise all the capital you need before breaking ground. Lenders will not commit time to such a project until the equity is in place, while equity investors will not invest until they know that the debt has been arranged.

Private market managers are able to back longterm, capital-intensive projects because they have raised long-term capital – their underlying investors typically agree to lock up their capital for five years or more.

Private asset managers also have the expert resources to assess the prospects of the proposed business model and understand the legal, regulatory, political and market environments in which the enterprise will operate.

This is expensive and time-consuming work, but it can be lucrative because issuers know that private capital will be relatively expensive capital. To compensate for the risks of investing in an illiquid asset, private funds need to invest at valuations that ensure the return on a successful investment will be more than enough to give investors the returns they expect.

Private markets solve problems for Investors

As mentioned, listed markets are not designed to finance capital-intensive enterprises, so they cannot give investors exposure to some of the most interesting assets and the most valuable cashflows in the economy. By contrast, private markets have the vision and the mandate to ‘fund the future’. This means that private markets offer investors exposure to entrepreneurial ventures that fall outside the remit of the listed markets: a power plant with a 20-year Power Purchase Agreement, a toll road with a 15-year concession, books of loans to farmers secured on their next harvest, or to African tertiary students to fund their college fees, or to South African pioneers of the sharing economy.

Private markets are perceived as ‘riskier’ than listed markets, but they offer access to more reliable, long-term cashflows and proportionately higher returns. Unlocking these unique opportunities requires fund managers with the specialist skills required to originate, manage, and then exit.

Private markets solve problems for society

Institutional shareholders’ adoption of ESG may drive incremental change in the behaviour of big companies but listed markets themselves are not equipped to solve the existential challenges facing SA and the world. These challenges include the just transition to a lower carbon future, efficient transport infrastructure, financial inclusion, ubiquitous education, and modern sanitation for African megacities. It is the private markets that have the imagination, skills and capital required to fund the leaps required to solve for the future.

No easy wins: what it takes to succeed in private markets

To make consistent returns in private markets, managers need networks in the real economy and the skills to analyse the full range of legal, regulatory, operational, and technological risks facing a project. In addition, the illiquidity of private market assets makes ESG mission-critical for asset managers for whom all positions are long-term. Private managers must therefore set high ESG standards for portfolio companies and then monitor performance consistently. Once an investment has been made, the manager must become a consistent partner in the business, monitoring performance, adding value to the board, and contributing to management’s strategic thinking. Things do not always go to plan, of course. There will be failures in the portfolio and an effective manager must also possess the skills and strategies to recover as much value as possible.

Private markets offer attractive risk-adjusted returns but require a greater level of effort to make money than the stock market. Investors should only select an established and reputable institutional asset manager as their partner on the journey towards the exciting new frontiers offered by private markets.