In this episode, we dive into private assets. What they are, their history, the risks and benefits and whether they suit investors.

Mark has written an article that covers private assets here.

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You’re able to find the transcript of the episode below:

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark LaMonica: Okay, there’s some pressure on us for this episode, Shani. Because when we get through this, Will, of course the producer of this podcast, gets to go on his bucks.

Jayamanne: On his bucks. Yeah. So we need to get through this quick.

LaMonica: We do. Will’s going to Vietnam, which is very cool for his bucks.

Jayamanne: Yeah, no chit chat this episode. Let’s get into it.

LaMonica: Okay. So we recently had a conference last week, Shani. So it’s a Morningstar conference for financial advisors, and there was a theme that repeatedly came out. And that theme is public private convergence. Now, that term might be unfamiliar to a lot of listeners. So Shani, what does it mean?

Jayamanne: Well, first we can define the terms. There are public markets, and that’s shares and bonds or any asset that is traded publicly, which means you can purchase those assets on an exchange. Then there are private assets. Traditionally, this has been venture capital and private equity, but now there are all sorts of other assets like private credit. These assets don’t trade on an exchange and are held and transacted privately.

LaMonica: And by convergence, it means that these two worlds are coming together. So we’ll get into the details, but private assets are now starting to be available for a wider group of investors through products like funds and ETFs.

Jayamanne: And in Australia, lots of investors have exposure to private assets through industry super funds that are increasingly investing in private assets. So maybe a good place to start is why do investors want private assets, Mark?

LaMonica: All right, Shani, we’re going back to Connecticut in the 1980s.

Jayamanne: Your glory days.

LaMonica: I mean, not exactly. I moved to Connecticut in the 1990s.

Jayamanne: Okay.

LaMonica: So I missed it. Just missed the glory days. So there’s a guy named Dave Swensen. He was working at Wall Street at Lehman Brothers. But in 1985, when he was 31 years old, even younger than you, Shani, he decided to take an 80% pay cut and move from New York up to New Haven, Connecticut, where Yale is located. And he became the Yale Endowment Manager.

Jayamanne: And the Endowment Manager is a person who leads the team responsible for investing donated funds to the university for the good of the university. One important detail is that these funds are supposed to last for perpetuity. Each year, a small amount of the fund is used to pay for things the university wants, but over time, it’s supposed to keep growing.

LaMonica: Now, back in 1985, this was a pretty boring job. All of these endowments were basically just 60% shares, 40% bonds. But Swensen took that big pay cut because he felt this sense of calling to go back to Yale. So that’s where he got his PhD in economics.

Jayamanne: Well, Dave Swensen took over an endowment of about $1 billion. And as Mark said, it was invested in the typical way that endowments were invested. But Swensen took a step back and started thinking about his job. There was something very unique about an endowment when compared with almost any other type of investment account. And that was the holding period.

LaMonica: Right. And we always talk about being a long-term investor. And when we say it, we are measuring long-term in decades. But for an endowment, long-term is way beyond that. So as Shani said, an endowment is supposed to last forever. So Swensen started wondering why an endowment was investing the same way as a person would invest in their retirement account.

Jayamanne: So Swensen started thinking about liquidity. And liquidity refers to how easily an asset can be converted to cash. So most publicly traded shares can easily be converted to cash, all you have to do is hit sell in your brokerage account, and soon you have cash instead of shares.

LaMonica: And investors like liquidity. So we can see how much investors like liquidity today, not even in 1985, just by this clear preference that’s developed for ETFs over funds. So ETFs are easier to convert to cash than funds, and investors seemingly favor them because of this.

Jayamanne: Now, in the investment world, if investors really like something, they tend to pay more for it. That increases evaluations and lowers returns. So Swensen thought with a forever-holding period when he didn’t really need the liquidity, it made sense to seek out illiquid investments, and he would get a higher return over the long term.

LaMonica: So that was the logic back in 1985. And that’s why Yale started moving into private assets. And this became a revolution in the investing world because Yale and Swensen did very well. So by the time he retired in 2019, the endowment was worth $29.4 billion. So his investing approach became known as the Yale model or the endowment model for investing. And many of the industry super funds follow this approach.

Jayamanne: So the question now that individual investors are starting to get more access to private assets is should investors take the leap? It seems like a no brainer given the fact that everyone is singing the praises of private assets as we witnessed at the conference. So what do you think, Mark?

LaMonica: Well, the first thing I would say is that whenever everyone gets really excited about something, it’s very important to be wary of it. And I think that there are lots of reasons to be wary.

Jayamanne: I agree. And I think many of the reasons are just common sense. In investing, it often pays to be first. You want to identify a trend before it becomes universally acknowledged as a trend. Then when everyone else buys into the trend, you profit.

LaMonica: Exactly. So in 1985, Swensen was one of the first that went all in on private assets. And as he was successful, more people jumped in and copied him. Now, we don’t have stats from 1985, but according to PitchBook, which is a Morningstar division that focuses on private assets, there was $9.7 trillion invested in private assets in 2012. In 2023, there was $24 trillion. So big growth there.

Jayamanne: And as more investors have decided they don’t care about liquidity, there is at some point where illiquidity premiums disappear. And remember that illiquidity premium refers to lower valuation levels for private assets, which means higher returns for investors. Well, according to McKinsey between 2009 and 2024, the valuation level on private equity transactions increased 83%.

LaMonica: Now, it is important to provide some context. All valuation levels went up over that time. But the S&P 500 valuation level over that time period increased by 44%. So private equity is getting more expensive compared to public markets, which means if it hasn’t already disappeared, there is less of an illiquidity premium.

Jayamanne: Let’s turn our attention to another thing that we always hear about private assets, and it’s that they offer better risk adjusted returns or about public assets. So what does that mean?

LaMonica: So it basically means that there is a lower level of risk as measured by volatility, given the same levels of returns.

Jayamanne: Now, we’ve been quite vocal that we don’t think that most investors should think about risk and volatility as the same thing. We think investors should think about the risk of not achieving a goal. For long-term investors, this means volatility doesn’t really matter, and what does matter is getting a high enough return over the long term to achieve your goals.

LaMonica: And there are some investors with short time horizons where volatility is a risk that they should be concerned about, because you need money in a year and the market crashes. That means you won’t achieve your goal.

William Ton: I’m Will, producer of Investing Compass and here are this week’s must-reads on Morningstar.com.au In this week’s Unconventional Wisdom column, Mark runs through the reason why private credit is a hard no for him. As investors rush into attractive yields offered by private credit providers, he urges caution and why that all that glitters is not always gold. Shani’s Future Focus looks at three ways to maximize your returns. Low fees, good behavior, and lowering taxes. Her column looks past how to find best investments but how to maximize the returns of the ones you have.

Public companies are taken over by private equity are usually done so at a premium to recent share prices. But does seeking out potential takeover targets makes sense for investors. In the latest edition of Bookworm, Joseph taps into the insight of legendary fund manager Anthony Bolton to arrive at three things that might make a company more attractive to acquirers. He also explains why investors should be wary of relying too much on this outcome alone.

99% of investors won’t be the next Warren Buffett. Luckily, we don’t need to be that successful. This week, Sim continues to explore products that make investing easier, with the newest edition of Young & Invested featuring a deep dive on one ETF portfolio. Are they a help or a hindrance to your goals? These articles and more they are in the show notes and let’s get back to Mark and Shani.

Jayamanne: So why do investors go so crazy over private investments?

LaMonica: Well, I think it’s just because we don’t think volatility is risk for most investors doesn’t mean that the industry doesn’t think the two are the same. So the great thing about private assets for the investment industry is that if you add them to your portfolio, you lower volatility without impacting returns. And since this is how success is measured in the investment industry, it’s kind of a no brainer.

Jayamanne: So I’m sensing a little bit of skepticism here. So why don’t you go through your thinking?

LaMonica: Okay. Well, here’s one way of looking at it. In many cases, these are the exact same assets. So the difference is the way that they’re valued and who values the private assets, the owners of those assets. So I’m not saying anything nefarious is up. There are procedures in place. There’s oversight from third parties, but that doesn’t change the fact that the valuation comes from a pricing model that is created by the very people who talk up the lack of volatility.

Jayamanne: And the interesting thing is that they are the same assets. For example, Sydney Airport was taken private by a group of private investors, including UniSuper. And there is a really interesting piece about UniSuper CIO, John Pearce, in the AFR. The AFR quote is, Mr. Pearce, who oversees $136 billion in assets, said that public markets did not always provide more accurate valuations, citing the 43% drop in Sydney Airport’s share price during the 2020 pandemic relative to the 11% fall in Adelaide Airport, an unlisted asset.

LaMonica: Okay, so think about this quote. So what John Pearce is saying is that the owner of private assets, including UniSuper, do a better job of valuing assets than the public markets. Now this statement in general is fairly shocking and we’ll get into it, but the evidence he is using is the drop in Sydney Airport share price during the pandemic. Sydney Airport is now private, but was publicly traded at that time.

Jayamanne: Now it’s easy in retrospect to look at what happened during the pandemic, knowing that for the most part things would work out and go back to normal. So now it is easy to say that the drop in the price of Sydney Airport was unjustified, but we didn’t know that at the time. We didn’t know that an effective vaccine would be developed, and we didn’t know that there would be no change in appetite for travel.

LaMonica: So I think it’s reasonable that Sydney Airport’s share price fell that much, especially of how far markets in general fell. There are just as many questions about Adelaide Airport only dropping 11%. Now we can argue all day about what the correct evaluation was, a 43% drop in publicly traded Sydney Airport or 11% drop in privately held Adelaide Airport. But let’s get to the theory behind this.

Jayamanne: Well, economic theory says that the markets do a better job of pricing things than an alternative. Markets in capitalism adjust prices defined in equilibrium between supply and demand, and use pricing as a mechanism to direct economic activity. If prices are high, there is an incentive to create more supply and vice versa. If prices are low, it generates more demand and encourages production cutbacks.

LaMonica: And this is the wisdom of markets. That doesn’t mean that markets can’t overreact occasionally, but the economic theory does not say markets are perfect. It just says that markets are better than other methods, and that other method is a more centrally planned approach.

Jayamanne: Work is of the wealthy night Mark.

LaMonica: I know, you’re so happy, Shani. So this isn’t a socialism capitalism argument. But if markets don’t set prices, who does? Well, then it’s the so-called experts who decide on prices. They use elaborate models to decide things. In the economy, this would be some central authority deciding production levels and what gets produced. In pricing assets, this would be the models of the owners of private assets.

Jayamanne: So things have gotten really interesting here. As you can see, you are comparing private assets to communism, Mark.

LaMonica: I mean, yeah, basically. But no, I’m not doing that. But let’s circle back to Dave Swensen and the original insight he had about the unique aspects of an endowment.

Jayamanne: And that insight was that he was running a fund that would last forever. So I think if Yale owned Adelaide Airport, you could make an argument that it didn’t really matter if the drop in price during COVID was 11% or 43%.

LaMonica: Exactly. That is very different than a superfund. It may not have mattered to Yale what the price of an airport was over the short term, but for a superfund or for a private asset that’s available to buy and sell on a daily basis, it really matters.

Jayamanne: And that’s because all during COVID, there were transactions for UniSuper. People were contributing money to UniSuper and they were buying in at a certain price. Retirees were selling at a certain price to take money out. Investors were switching investments within UniSuper. So the price of all those transactions that occurred did matter.

LaMonica: Yeah. And there are obviously some questions there. And ASIC is looking into the valuation policies of superfunds. But I do think we need to acknowledge that the lower volatility of private markets is largely just a result of the way the valuation models are designed. So low volatility is not some great feature of private markets. It is part of the design.

Jayamanne: And Sydney Airport is illustrative. It was taken private after COVID, but if it was private before, it would not have fluctuated as much in price. But it is the same asset. And more than anything, it is a good reason to ignore short term price movements in public markets.

LaMonica: So there’s a lot more we can talk about with private markets, but Will needs to go to Vietnam. So I will say that Australia is behind Europe and the US when it comes to offering private assets to individual investors directly. So as that starts to happen, we will obviously have a lot more to say about it. And we’ll go through some specifics that investors should watch out for.

All right. So that’s it Shani. We’ve made it. Will can go to Vietnam, do whatever he does. I think cultural tours mostly at his bucks party. If you have episode requests for when he comes back, if he comes back, then please send them into my email address or put them in the comments on YouTube or Spotify.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)