Doing Your Due Diligence on Private Markets
19:02 Share

This is an iHeart Podcast.

Learn how at AmazonBusiness.com.

Switch to Verizon Business and get more from your internet without paying more for your internet. Get LTE Business Internet starting at $39 a month when paired with select business mobile plans. That's unlimited data and with it, unlimited possibilities. Start saving today with Verizon Business. Ranked number one in small business internet customer satisfaction by J.D. Power.

Starting price for 25 megabits per second LTE internet plan with smartphone plan savings, plus taxes, fees, and economic adjustment charge. Terms apply. For J.D. Power 2024 award information, visit jdpower.com slash awards. What does being financially invested sound like? A retiree on a cross-country drive? Someone with new long-term goals? A student getting their start?

With over 450 ETFs, iShares gives you access to countless market opportunities. iShares by BlackRock. The market is yours. Visit www.iShares.com to view your perspectives, which includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing. Risk includes principal loss. Prepared by BlackRock Investments LLC and member FINRA. Bloomberg Audio Studios. Podcasts. Radio. News.

Welcome to Merrin Talks Your Money, the personal finance edition of Merrin Talks Money. In these bonus podcasts, we talk about the best strategies for making the most of your money. I'm Merrin Somerset Webb, and this week we are focusing on private markets. It's not a topic John and I discuss that often, except for in a mildly disparaging way, but it is something many of you have written in about. So we have decided to invite in a guest to help us talk about why

you might want to get into private credit, private equity, et cetera. And if it's an investment path that you want to go down, what exactly are the smart ways of interpreting what is out there? So with me, Morningstar Chief Executive Officer Kunal Kapoor. Morningstar is a leading provider of independent investment insights and ratings based in Chicago. Kunal, thanks so much for joining us today. Thank you for having me, Mary. Now, all

of our listeners and readers will be very, very familiar with Morningstar because lots of them, the first thing they will do when they go and look for a fund is they'll look up your rating on it and they'll see whether it's a gold fund, a silver fund, a bronze fund, etc. There's various different ways of rating. But everyone is familiar with the idea that when it comes to

ordinary listed funds, holding assets in the public markets. You are one of the go-tos in the markets for information and also for education. You provide a lot of research and education for ordinary investors. But...

You're moving into a new-ish area, which is looking more at rating the private part of the market. So private credit, private equity, infrastructure, real estate, these kinds of funds. So tell us a little bit about why you're doing that and what sort of funds you'll be looking at. Vehicles, should I say.

Yeah, let's dive right in. And let me just start by saying that I think your skepticism is warranted. Anytime you see a flood of money chasing a trend or anything like that, I do think putting a skeptical view on things is appropriate. And I have no doubt that as there's some new products that come out in this space, there are going to be some lousy products and it's going to be a morning start job

to help investors navigate them. But if I back up further and kind of try to provide a broader view of what's going on, around the world, as you know, there's just been a preponderance of money that's flowed into the private markets. And it's happened in private equity, where you see the number of companies that

In private markets that have taken funding from private equity far exceeding what's available in the public markets. In Europe alone, you have double the number of PE-backed companies relative to public companies. So just to contrast that. That is absolutely true in terms of numbers of companies, but in terms of value of companies, the listed markets still remain the higher value area, right? Yes, the largest companies for sure are public.

listed. And that makes sense. But it's notable that the size of private companies has gotten larger and larger. And so that's notable. Yeah, it is one of the things that we talk about a lot, which is this idea that companies list later and later and later if they list at all. So an awful lot of the growth that one might have previously expected to get access to all the public markets is now only in the private markets. Correct.

Now, while private equity gets a lot of the headlines and you can see why it's much more, I think, enticing to write about it and talk about unicorns and whatnot, the reality is that most of the action is really in private credit. And where investors like you and I and wealth managers are going to first encounter the private markets is really in private credit. And so if you go back to post-COVID,

global financial crisis, a lot of the big money center banks around the world came out of that either facing new regulations or generally taking a more cautious approach to how they wanted to manage things or candidly being in a situation where they didn't have the capital to lend as much as they previously might have. And so that opened the door

to what I'll call sort of non-large banking lenders emerging. And you saw particularly private equity firms starting to step into this space. Some built up insurance capabilities and whatnot to invest here. And so private credit has really taken off. And in many large markets around the world,

An increasing amount of debt is issued via private markets. And so what you're starting to see in some parts of the world is the arrival of products available to retail wealth investors that essentially allow them to access the private credit markets. So what we're talking about when we talk about private credit is...

companies that are unable to borrow from banks or unwilling to borrow from banks looking for alternative places to borrow money and going to private companies to do that.

It's that simple. That's what we're talking about. Exactly. They're raising the money via non-banking financial institutions in many instances. Yeah, but that debt remains tradable, just not on a listed exchange. Yeah, I think tradable it could be, obviously, but they tend to be held in private hands and so they don't trade as much. Obviously, that's a bit of a distinction from what we call public high yield, which does trade.

although it's very debatable as to how liquid that is as well. Okay, so we're talking about entirely a liquid high-yield debt. Yeah, that does not trade by the moment, for sure. I mean, what is the crossover between modern private credit and olden days subprime lending? Yeah, I think what you want to be careful about is you don't want to throw the baby out with the bathwater. There's certainly, as in the public markets, when you're investing in debt...

the higher the chance of default, the greater the interest rate that you're going to demand. And you see that in private markets as well. Candidly, Marin, there's a high degree in my view of likely correlation between public and private markets because we are kind of in a period where

things have generally gone well in the public and the private markets. And so generally speaking, risk is something that I think people have been de-emphasizing in a way that is going to probably be problematic regardless of whether you're looking at public or private markets if you have a correction. So I think your line of questioning maybe is heading down the path that private is maybe

More risky. There's certainly some factors that make it so, but I wouldn't say that in a wholesale manner, if you look at some of the lenders and firms that got involved, you have large firms like the Blackstones and the Apollos of the world. They come with solid reputations and, you know, the ability to do the research just as you would expect on the public side as well.

No, sure. I suppose my question really is that if you are a company and you need to borrow some money, your first port of call is going to be a bank or publicly listed markets because maybe that would be cheaper for you. So if you end up not going to a bank, no? Not anymore. It certainly used to be the case that one could generalize in that way. But you're starting to see, even when there's large M&A taking place, that many firms are not going to the public markets and they find it quite efficient to

to go to the private markets to raise money. And so I think that is the underlying point here, both in terms of equity and credit, is that what used to just be the purview of public markets is no longer just that. You're right to be skeptical at a high level, but the underlying trends show that there is some change in terms of the nature of what's available to invest.

on the private side of the ledger. Although we vaguely wonder if there won't come a day when in the equity side, we'll move back to people being more interested in listed than private, given that as rates don't go back to their previously low levels, it becomes increasingly obvious that the private equity outperformance is not quite what maybe we thought it was. So we wonder if on the equity side, at least, we might see a swing back towards listed.

I think that's a really important point. But in general, I would say that investors should expect lower returns from public and private markets going forward.

Now, I would probably agree, certainly in the US, maybe if not elsewhere. But I suppose the point about that is that if it is the case that in times of normal interest rates, private equity returns are more or less the same as public equity returns, i.e. it turns out that private equity is simply equity with not much transparency and a whole pile of debt. Why would you take private equity over public equity? And that's a question that I think we will have answered over the next decade. Yeah.

Yeah, that's totally the case. And we'll need to look at that. I think it's hard to generalize. And at least so far, our data, so we own PitchBook, and so we have years and years of data on this. It does show that while you're trading liquidity, you do get a little bit of return premium. And so you're right, we'll have to see. But my hunch is that the markets are going to be way more correlated on the public and private side than most people believe. And so we'll see how it plays out.

We are constantly being told that we use private equity as a diversifier, but you're rather suggesting that going forward you don't see that as the case. I think it's true of most asset classes today that because they've all had strong runs, there's a higher degree of correlation and

It's going to be harder to differentiate. That's my personal view. I realize others feel differently, but you just have to look at this year and even what happened in April, you had the public markets kind of fall sharply before recovering. And similarly in private markets, while you didn't have a mark-to-market event, so to speak, you certainly didn't see deals getting done. And now again, with the public markets back, you're sort of starting to see a desire to get deals done again. So it seems to me that there's...

more correlation than is the case. Clearly, if you can hold something for longer, though, which is the case with private equity, I think potentially the benefit is you're not trying to trade in and out. Maybe that explains some of why the returns have been different. Kind of less you can hold it for longer than you have to hold it for longer, right? Correct.

So when you talk about going into this market, you're talking about beginning to rate what you call semi-liquid funds. Explain to us what we mean by semi-liquid. The notion of a semi-liquid fund in the U.S., it's large in the category of what we call interval funds. In Europe, it's in the category of things such as LTAFs, so L-T-A-Fs.

And the notion with these types of investment vehicles is that you can come in and out of them on a schedule or a schedule. And what I would say is that they are different, obviously, from the funds that you and I started this conversation talking about because those have instant liquidity, essentially. If you're in an ETF, for example, it's near instant liquidity. If you're in a regular mutual fund, you at least have daily liquidity.

And what you have in semi-liquid funds is a situation where you get liquidity, let's say, once a quarter. So there's a predetermined date where you can buy in or sell out. And this allows the manager to take the assets and then put them to work in investments that are not liquid.

But the benefit, at least of these types of vehicles, is that they do provide access with some degree of liquidity relative to what a traditional private equity or private credit fund would do, which is not provide liquidity for a longer period. Tough on a manager if they know when they have to produce cash. They don't know how much cash and if in private equity and private credit you are holding for the long term, particularly in private equity, you can't be sure that you can exit at any particular time. It's still a tough way to manage money.

It's a tough way to manage money, but it's no tougher than on a daily basis when you have to provide liquidity, you know, based on who's coming in and out. So I don't find that to be an insurmountable challenge. Daily liquidity funds have all kinds of challenges too. You have to kind of anticipate and hold cash, for instance, to think about what's coming in and out. So I don't view that as insurmountable. I think what's the bigger challenge is are you really adding value and providing a premium for the reduced liquidity that

you're providing in that vehicle? And our ratings essentially go to try to answer that question and also to put public and private on an equal footing. So if you're going to buy a private vehicle, not only do you want to make sure that you get the benefits, but you want to make sure you outperform the public vehicles. And so we want to be conscious of not separating the public and private universes entirely and

And you'll see that in our methodology when we roll out these ratings beginning here in the U.S. in the back half of this year, that the idea is also to really rate them based on our view of whether they're going to outperform similar strategies in the public markets. And how are you going to form that view?

Well, our analysts obviously are going to do the diligence as they do on public market vehicles today. So, you know, it starts by working to understand the parent, you know, building these vehicles so we have a parent rating. And then from there, we dig into the actual management of the fund and produce an opinion based on our view of management's ability to deliver outperformance as well as, you know, key factors such as expenses.

Expenses and fees are an interesting part of this whole sector. I mean, the whole sector is more opaque than one would like a lot of the time. The fee structure is something that ordinary investors have some trouble getting to grips with quite a lot of the time. This will be included and rated, right? Yeah, yeah. It's no different than the fight, morning star fight in public markets to get common investors access to money.

you know, knowledge about what they are paying today. And so I think transparency is a good thing. Investors, I think, will have that opportunity here in the private markets by bringing some transparency and competition. With your sense of how private equity, private credit is becoming part of the investing universe. And I talked earlier about, you know, the likes of Larry Fink and how much they think one should have in a private portfolio. What do you think

a portfolio should look like these days in terms of allocation to private assets? For most rank and file investors, let me just start by saying simplicity really matters. And if you feel good about your portfolio and you're all in public markets, public equity and public debt, I think that's fine. You don't have to change that. This isn't for everybody. And one of the most important things about investing is that it should allow you to sleep at night and to hit your goals.

And if you can do that with the portfolio you have, you don't necessarily need to change that. I think for most rank and file investors going forward, if you have an interest in the private markets,

The reality is, at least in the near term, it's going to be hard to get true access to private equity. And so I have a hard time saying you should be allocating X or Y because the vehicles as yet aren't in place to provide that at scale. They will be in time. My personal view is that where these belong is in your retirement assets.

And even in your retirement assets, if you've never owned something like this, it's probably good to start with a very small allocation to the extent that you're interested so that you can start to get a feel for what it means to have something like that in a portfolio. Because you will really immediately understand what it is to not have the type of liquidity available.

that you otherwise might have. And so I would say that for most investors today, starting off with no more than about 5% to 10% of your retirement assets parked in these vehicles is probably an appropriate way to learn a little bit about how you feel about them, how they behave, how you want them in a portfolio. So if you are already retired, possibly even have started drawdown, this may not be the asset for you.

I would say that's accurate. Well, while we're on the subject of retirement assets, how do you feel about the British government, about Rachel Reeves' idea that some of our pension funds should be obliged to have 10% of their assets in private markets? I think it's a good idea for long-dated asset pools to have exposures.

to the private market. So I like that idea. I'm personally not off the mindset that it needs to be prescriptive. I think ultimately these are pools of money that are and should be managed by professionals who should have clear opinions and

what types of allocations they want. And you certainly see around the world different pools of asset owners that have different views on this, going from some that don't put anything in private markets to some that are well-known and have chosen to put close to half their assets in private markets. So I think at a high level, I absolutely agree that it's a good idea for long-dated asset owners to be looking at the asset class. But I think the

ultimate driver should be matching the time horizon to the liquidity needs of those that you're serving. And so I would sort of leave that up to the individual investment officers there. That is all fascinating and really useful. And I think that we'd all be really, really pleased with what you're doing. And the idea of bringing transparency, a little bit more due diligence, et cetera, to a market like this and helping people get into it is super helpful.

Thanks for listening to this week's Merrin Talks Your Money. If you like our show, rate, review and subscribe wherever you listen to your podcasts. Also be sure to follow me and John on X or Twitter. I'm at Merrin SW and John is John underscore Stepak. This episode was produced by Sam Asadi, production support and sound design by Blake Maples. Questions and comments on this show and all our shows are always welcome. Our show email is merrinmoney at bloomberg.net.

Switch to Verizon Business and get more from your internet without paying more for your internet. Get LTE Business Internet starting at $39 a month when paired with select business mobile plans. That's unlimited data and with it, unlimited possibilities. Start saving today with Verizon Business, ranked number one in small business internet customer satisfaction by J.D. Power.

Starting price for 25 megabits per second LTE internet plan with smartphone plan savings, plus taxes, fees, and economic adjustment charge. Terms apply. For J.D. Power 2024 award information, visit jdpower.com slash awards. Thrive End can help you plan your finances for the people, causes, and community you love. What makes Thrive End different? Financial services and generosity programs are combined to help you build the financial roadmap for the future.

while also creating opportunities to give back along the way. Visit Thrivent.com to learn more. Thrivent, where money means more.

In business, plans change fast and your brand has to keep up. That's why teams rely on 4imprint for promotional products that deliver. 4imprint offers thousands of options including apparel, drinkware, tech, and trade show gear. Many available with 24-hour turnaround, helping you move quickly and never compromising quality. You'll enjoy free samples, expert support, and every order backed by their 360-degree guarantee. So it arrives right and on time. Explore more at 4imprint.com. 4imprint. 4surf.

This is an iHeart Podcast.