The Power of Private Markets

What are the drivers of private capital growth?

• 1. The search for higher returns and greater diversification

  Up until recently, interest rates were at historically low levels for a sustained period. In Switzerland, the official policy rate was either close to or below zero from 2008 to 2022 (see chart below).

  Swiss money market rates
  Source: Swiss National Bank

  The prolonged period of low interest rates suppressed returns from traditional investments such as deposits, cash instruments, and bonds. At the same time, it made debt cheap, meaning leveraged funds had extra funds to invest.

  Not only this but even more liquidity was poured into the financial system after the 2008 financial crisis and the pandemic, as governments and central banks responded by providing “emergency” liquidity to banks and consumers.

  With all this available cash, investors sought somewhere to go to make decent returns. Some of this capital flowed into the equity market, particularly growth stocks. However, a considerable portion found its way into private capital.

  Institutional investors, pension funds, and high-net-worth individuals (HNWIs) began allocating their funds toward private equity, debt, real estate, and infrastructure. These alternative assets offered relatively higher returns with less volatility than public markets. For example, the chart below illustrates the returns from a hypothetical dollar invested in the S&P 500 versus Cambridge Associates LLC US Private Equity Index between 2000 and 2023.

  The net growth of a USD 1 hypothetical initial investment
  in the referenced indices on January 1, 2000*
  Source: Cambridge Associates LLC, Yahoo Finance

  * The methodology behind the calculations focused on establishing parity in the measurement frequency of both indices to a quarterly basis. This adjustment was made due to the fact that investment-level performance information of private equity funds behind the CA PE Index is drawn from the fund managers' quarterly and annual financial statements.

  The chart is made for illustrative purposes only, as neither the Cambridge Associates LLC US Private Equity Index nor the S&P 500 Total Return Index can be directly invested in. These indexes are simply measures of the performance of their constituent securities.

  Speaking of the rising popularity of real estate and infrastructure investments, this can be mostly attributed to the return of high inflation, as well as to the fact that these assets exhibit a generally positive correlation with inflation.

• 2. The banking sector’s retreat

  “Banks don't want certain asset classes, and that's created opportunities for private equity, hedge funds, Silicon Valley.” — Jamie Dimon, CEO of JPMorgan Chase

  Starting in the 1980s in the US, and later in the 1990s and 2000s in Europe, the banking industry witnessed significant consolidation through mergers and acquisitions, as depicted in the chart below. These bigger banks shifted their focus towards catering to larger corporate clients, leading to a strategic retreat from mid-sized and smaller customers. The introduction of Residential Mortgage-Backed Securities (RMBS) also caused them to lose interest in the residential mortgage market.

  The number of FDIC-insured commercial banks and branches in the US
  Source: Statista

  In the US, the repeal of the Glass-Steagall Banking Act in 1999 allowed commercial banks to pursue investment banking strategies, which resulted in a further retreat from their traditional business model.

  These trends were also further amplified by the increasing capital requirements imposed by the international Basel regulations, particularly with the implementation of Basel III following the Global Financial Crisis (GFC, 2007-09). As the demands for higher capital increased, banks naturally became less interested in certain markets.

  Consequently, as banks retreated from certain sectors, the resulting voids were filled by private equity and private debt funds. In the US, banks now service less than 10% of the leveraged lending market, while in Europe, their involvement in the market stands at around 35%.

• 3. The loss of interest in IPOs

  With the rise of venture capital and pre-IPO private funding, startups and growth firms discovered an alternative source of funding, which put the disadvantages of IPOs into stark relief.

  As a result, private companies like SpaceX are now opting to postpone or completely forgo their IPOs. This has led to a dramatic fall in the number of IPOs over the last two decades, while simultaneously creating greater investment opportunities for VC and private equity investors.

  The tendency to avoid IPOs is more than a small trend. Between 1980 and 2000, there were more than 6'500 IPOs. Between 2001 and 2022, there were less than 3’000.

  Amount of IPOs since 1980
  Source: University of Florida

  There are four main disadvantages to IPOs as well as to maintaining a public status:

  a) IPOs are expensive and take too long

  IPOs usually require six to nine months for completion and can cost over USD 10 million, even for a small deal. The rise of SPACs (Special Purpose Acquisition Companies) in the US and similar vehicles in other regions also highlights the challenges and expenses associated with traditional IPOs.

  In light of the foregoing, rather than listing themselves, startups are instead choosing to be bought by a SPAC with an existing public listing.

  b) Stock market volatility is distracting

  Publicly-listed companies face daily fluctuations in their stock value, and when groupthink kicks in, their share price can experience extreme swings in either direction. This can be highly distracting for management, particularly when they must hold shareholder meetings and confront the press to constantly explain what is happening with the share price.

  According to research conducted by State Street Global Advisors, the S&P 500 and Russell 2000 (small caps) are actually more volatile than the State Street Private Equity buyout index.

  Comparison of the volatility of public and private equity indexes
  Source: State Street Global Advisors

  c) Public companies don’t have the bandwidth to maximize their value over the long term

  Given the scrutiny on their share price, the management team of public companies is often forced to focus on short-term fixes rather than long-term strategies. By choosing to remain private for a longer period, companies gain the opportunity to set their strategy up for long-term success.

  d) Too many reporting requirements

  When a company goes public, it inevitably faces a significant increase in the time and effort dedicated to financial reporting and investor relations. This shift can transform even the most agile startup into a bureaucratic organization. It also forces founders to either mature with the company or step aside.