Investors First: The Convergence of Public and Private Markets

Kunal Kapoor: Good morning, everybody, and welcome to the second episode of our LinkedIn Live series where we’re going to talk about the convergence of public and private markets. Now, if you’re like me, I know what you’re thinking: Thank God, this is not another conversation about whether the Fed is going to cut rates by 25 or 50 basis points. We’ll all find that out in an hour or two, and then we can get back to our lives.

Instead, this is a really important discussion on an investing trend that is very material and likely to be one that we’ll be following for a long time because it’s going to impact how we all invest. And joining me today are two of my notable colleagues here in Chicago, Brian Moriarty, and in Seattle, Nizar Tarhuni.

Brian and Nizar, maybe you could quickly introduce yourselves and then we’ll kick it off from there.

Brian Moriarty: Sure. Thanks, Kunal. Hi, everybody. I’m Brian Moriarty. I’m a strategist with Morningstar Research Services’ manager research team. I’ve been with Morningstar for almost 12 years now and very excited for this conversation.

Nizar Tarhuni: Hey, everybody. Good to be here. My name is Nizar Tarhuni. I’m executive vice president of research market intelligence at PitchBook. I’ve been at PitchBook for a little over 10 years. At PitchBook across our analyst groups, we cover the core asset classes of private equity, venture, and M&A, as well as the industry and technology sectors funded by that capital.

Kapoor: Now starting with you, how is the convergence of public and private markets affecting the landscape? When I started at Morningstar 25-plus years ago, there were more than 7,000 publicly traded companies. Today, the number is more like 4,000. Meanwhile, when you talk about private debt, a lot of it was issued through what I’ll call traditional commercial lenders. A lot of that has moved away. And so, you’ve got private equity and private debt that are far more prominent. What does it mean and what are you seeing in this context?

Tarhuni: I think about the convergence in two buckets. One is a convergence of products that are starting to look similar, and we are seeing that mostly on the credit side. And I think about convergence in terms of—I know it’s kind of a buzzword—but the democratization of access to private capital markets, primarily as you think about private equity, venture, and real assets.

I think if you zoom back a little bit, 20 years ago, you had an asset class, call it, total private markets, real assets infrastructure, private equity, venture, and credit, that was about $200 billion or so in assets—$200 billion to $400 billion in AUM, or net asset value, and today that market is over $10 trillion. And during that time, what you’ve seen is that the capital pool that has traditionally funded that has been the same, and so there’s an investment shift from the large asset managers, which today account for—so, think about the likes of BlackRock, Apollo—account for about 50% of all fundraising in private markets, specifically in private equity. And so, that market is looking to diversify its capital pool into a high-net-worth pool that is also able to take a bit less liquidity given that they have longer time horizons and investment horizons and have become more sophisticated. And so, what you’ve seen is this proliferation of products like interval funds to provide some sort of liquidity or semiliquid vehicles to try to target that market. And what you’ve seen is a pretty successful appetite. You certainly see that with Blackstone in the first mover there from high-net-worth and other retail individuals who are looking to invest. So, that’s kind of looking at the capital pool getting wider.

In terms of convergence on the credit side, what you actually see is a shift from borrowers who no longer look at private credit versus the capital markets and bonds or versus bank loans as differently. They tend to be fairly open to the channels from which they take capital, and what you’ve basically seen post-2008 is that there isn’t as much liquidity in the broadly syndicated loan market or in the high-yield bond market to the extent that you would think that you’re really getting more liquidity and are willing to be in that market versus private credit. What you tend to see is that today I think some of the stats out there that you have an eighth of the liquidity in the broadly syndicated loan market than you did in 2008. And so, because of that, you’re much more open to being in private credit. And private credit has evolved and provided the same types of structures and paper and capital structures that you’ve been historically able to get in the broadly syndicated loan market and the bond market, and so the products are just starting to look very similar with different capital bases backing them.

Kapoor: Brian, Naz used the terms “access” and “democratization.” Those are words we like. I get they’re overused. But the reality is that if you’re a wealth manager or an advisor or you’re a retail investor, such offerings kind of felt out of reach. They were with high minimums, the tax situation with them is not easy, the liquidity is an issue. And so, from your perspective, what are you seeing change in terms of how it’s truly getting democratized and importantly, should people care?

Moriarty: I think there are a few things to consider. One is that if you’re thinking about this topic from someone who wants broad market exposure—this is how I approach the market—as more and more of the markets move from public to private, that means the broad-market passive ETFs are capturing less and less of the world. And you could even argue that the massive growth of just a few public companies in recent years has further skewed this dynamic, right? ETFs are providing less diversified market exposure than they used to even just a couple of years ago.

And so, stepping into that are products like interval funds, for example, that are taxed just like a mutual fund, that trade on a ticker, that have the same legal protections as a mutual fund. It offers a very familiar experience to advisors and their clients while also opening the door for them to invest in things like private assets. Naz made a great point on the private credit markets because those are much closer together than the public equity and private equity markets. Private credit and public credit, they’re basically touching, and there’s a lot of overlap, and so that’s why we’re seeing a lot of the products coming to market trying to capture that convergence specifically the credit markets because that’s where people are going to get the most familiar experience and obviously meeting needs like retirement income and so on.

Kapoor: Brian, you touched on interval funds, and one of the advantages of an interval fund versus a traditional open-end vehicle is obviously the money is locked up—advantage or disadvantage I guess from your perspective—but advantage in the sense that because the money is locked up, you’re less likely to react to a bad period and want to get your money out. And one might say that if you look at our data, target-date funds and things like that where investors have had to stay in investments have been more successful. And then if you kind of take that over to the private and VC side, one might argue time horizon has something to do with that as well. Yet, some of the products being launched are going to be pretty liquid. Last week, you had the State Street announcement of an ETF that they’re working on with Apollo, and this one is going to be geared specifically to the private-debt side of the ledger. What’s your take on access where liquidity is going to be seemingly available anytime, that is a shift, and what does it mean, and how are you sizing up these vehicles?

Moriarty: That’s a huge shift. That’s groundbreaking, probably on par with the bitcoin ETFs. We have a lot of questions and reservations about that. I think at minimum, it’s really jump-started the conversation of can this be done in an ETF and really put the question to the SEC. So, a lot of our questions really revolve around pricing and liquidity. When you put private assets in a liquid wrapper like an ETF, pricing because the ETF needs to be able to calculate its NAV, investors and market makers need to know, need to have an opinion on the value of the ETF’s portfolio. And on the liquidity side, that’s just the ability to trade. People need to be able to trade in and out of these assets.

The issue, at least historically, with private markets is that they were priced very infrequently, typically quarterly, and they were very illiquid, very hard to trade, maybe even impossible to trade. But what Apollo and State Street are doing is, Apollo has essentially promised to provide a bid on these assets. They’ve promised to buy these assets from State Street. And if State Street says, “Hey, you have to buy them,” Apollo can’t say no. And so, they’re saying with one solution, with this bid that Apollo is providing, really attempting to cut through the pricing and liquidity sort of Gordian knot, if you will, with really one swing of the sword. And it’s very creative. We have a lot of questions around it. But I think at the very least, like I said, it’s put the question to the market, to the SEC, is there demand for a product like this and will the SEC approve a product like this? And if the answer to both of those questions is yes, then we might really see the floodgates open of bringing historically the most inaccessible parts of the market to historically the most accessible parts of the market in just the snap of the fingers. That’s a huge shift.

Kapoor: It might potentially weaken the argument for an interval fund for those who don’t want to hold on to it, right? Regardless of what benefit there might be.

Moriarty: Absolutely.

Kapoor: It’s worth watching for sure. So, Naz, I would imagine though if some of our analysts are looking at this—and we’ve got a skeptical bunch as usual on the analyst side, which is good—but I imagine they’re looking at this and saying, “Some of these PE shops have so much money that they’re managing. Why on earth do they need this channel at this point?”

Tarhuni: I think that it’s a good point in terms of the skepticism. We literally had a conversation yesterday about there could be, and I’ll just say it frankly, perhaps selfish or self-interested reasons for wanting to tap a different pool than the institutional pool. As I talked about earlier, the market went from a few hundred billion to $10 trillion over a 20-year period, yet the pool of capital that’s on the institutional side that is available to invest in, that hasn’t grown at that same clip. And so, when you think about a large set of firms—let’s think about specifically private equity and credit for now—some of which have become public in order to provide liquidity solutions to founders and management teams that have been there for a long time, what ends up happening is, if you’re invested in those securities as a publicly traded company, you’re not invested in the underlying funds and the carry returns that you might be able to generate there, you are effectively participating in the management revenue. And the management fee revenue is effectively tied to the AUM that you’re building.

And so, if you think about where can you access net new capital pools in order to bolster your capital base? One of the places you might have to look to do that today is different channels than you have historically, which comes with high-net-worth and family offices and other retail channels. To do that you have to create the wrappers to be able to make them comfortable in a market where they don’t have the same level of sophistication or the same resources as some of the institutions. And so, there might be self-interested reasons for doing that.

That being said, when you have large capital bases of that scale all moving in a similar direction, I think you also want to be cognizant of not betting against it and trying to figure out how could this perhaps work. And I think one thing that many industry participants will point out is that if you look at the equity markets, also your liquidity no longer comes from exchanges. It comes from actual private vehicles that are providing that liquidity and it made a market there. So, Apollo might be the first to say for the loans that we originate, we will make the market to buy them back if we have to. But it’s not a stretch to think over time that other firms might even see that corner of a market of being a market maker in a large credit business where the industry in the United States is 70% funded through the private credit channels that there might be others who want to make that market. And from there, you actually start to generate liquidity.

I think the one thing that we’re pretty skeptical on is the value of the marks because I think the culture of a credit investor is. “Don’t lose my money and give me the spread that you told me you’re going to give me” versus a mark on the actual fair market value of what that paper is worth today, which is what you get in the syndicated loan market. And so, the bet that I think we’re skeptical of is that folks really want to trade this paper for excess returns, given that you already are getting a premium spread and a premium return typically in private credit, what is the impetus to make you actually want to trade it and thus, what is the impetus to force you to want a fair market value every day?

Kapoor: Right. So, we’re already starting to get a fair number of interesting questions. And so, I’m going to pivot to mixing some of my own questions with some of what’s coming in from our audience. And I’m going to take one here from the audience, and I’m going to put it to you first, Naz. It seems investing in private assets only makes sense if you have access to top-quartile managers. And actually, I hear this all the time from wealth managers who are going to provide access, we’re only going to give the top-quartile. First of all, won’t giving retail investors access to private assets dilute those returns potentially? And also, are the top-quartile managers really going to care about the space?

Tarhuni: Yeah. So, Here’s what I think is interesting. I think in the broad retail world, private markets get lumped in as one. And I think from our vantage point, we look at private markets and we actually think about them as completely different asset classes of the subsets that sit within it. We look at venture completely differently than how we look at private equity. Within private equity, we look at buyouts completely different than how we look at growth equity. And within credit, we look at structured products and special situations of private credit completely different. And within private credit, we look at corporate lending and sponsor-backed buyouts versus asset-based lending completely different as well.

When you think about the venture markets, you look at the “Mag Seven,” or I’m not even sure what they call them anymore in the public equity markets, but the largest firms there, yes, typically they were venture-backed, and they were unicorns, and they created a tremendous amount of value in the public equity markets, and they hold that monopoly there. But the reality is, in a venture portfolio you have perhaps one of those companies every vintage, sometimes you don’t even have them every vintage, they come every other two, three, four years. So, the scale isn’t actually there from a volume perspective. And if you looked at the persistence of returns in venture, the question is, it’s real. There’s a very stark difference between the bottom quartile, the middle quartile, and the top quartile. And what you tend to see with the top-quartile managers is they run capital-constrained strategies. They run $300 million, $400 million, $500 million tops, and they never have changed that. And the folks who have tended to grow AUM in venture have tended to see their return slip away. And so, you look at firms like Benchmark or Sequoia, they have run very focused, very constrained, small teams, equal economics across the teams, and that has worked very well for them. But what that leaves you with is more capital doesn’t actually equal to more returns.

When you look at buyouts, if you look at private equity—and we run our benchmarks over the last 20 years—and you run the equal publicly traded equivalent of a PME, so a dollar in private equity for a vintage versus a dollar in the equity market, well, you see since 1999 there have only been four instances where private equity has not outperformed the public equity markets. And in many of those years, that outperformance comes from somewhere near 1,000 to 1,200 bps [basis points]. And so, it is material. And so, I think what you see is that for a portion of the market, if you can isolate private equity and private credit, I think private credit has a similar number. There have only been five years where private credit returns have underperformed what you’d get in the high-yield bond market. If you can isolate for those markets, on average, you are going to do better. And the premium of investing in those markets have tended to pay off. That is not top or bottom quartile. So, I would separate venture and I would look at private equity buyouts and the credit markets a bit differently.

Kapoor: Great answers. And Brian, here’s one for you as well that’s come in. Do you expect to see where there are TAMPs that are in existence that have focused on the public side of the equation, do you anticipate that they are going to work more closely with the iCapitals of the world and bring together the offering? I think this is really a question of how does it come together for an advisor in a portfolio, if you will?

Moriarty: I think so. Before I get to that, I just wanted to throw one addition to Naz’s answer just on the second- or third-tier managers. If something is at the right price—my colleague, Ryan Jackson, pointed this out the other day—you might be getting the second- or third-tier manager or the second- or third-best idea from a top-tier manager, but at the right price, let’s say a very cheap ETF, that might still be worth it given the exposure that the advisor or the investor wants in their portfolio. Just something nuanced to think about.

To answer the direct question, I think what we’ll end up seeing is, yes, some sort of convergence around either portfolio construction, TAMPs, or model portfolios, where these services are offering the ability to invest in some type of private fund, whether that’s an evergreen fund, an interval fund, something that’s offering access to private markets. And we will see maybe a reshaping of the typical asset-allocation pie, where for example, the high-yield or leveraged loan part of the historical asset-allocation pie gets moved to the private credit markets or at least something that can invest across both. So, for example, the interval fund does great investing across both public and private and toggling back and forth or offering that total leveraged credit exposure, the income-seeking part of the portfolio. So, we could see a shift from using mutual funds in public credit to shifting those assets to the private credit markets.

But something that’s also worth thinking about, and I’m sure advisors have thought of this already, is that you can’t really shift all of your exposure to something like an interval fund, something that’s locked up or harder to get out of, for rebalancing purposes. It makes it harder to rebalance on a schedule and makes it harder to rebalance in response to market moves. And so, I think we will see some shift into maybe the interval fund or tender offer fund market, but not a complete shift. Now obviously, if the ETFs become the dominant way of accessing this, then that actually solves also this rebalancing question.

Kapoor: Right. So, here’s a question that I’ll post to both of you, and feel free to jump in. What role does data have in sorting through all of this and helping navigate and comprehend what’s happening? And secondly, how do we think about indexing in this context? Because how does an advisor sit with a client and actually explain how they’re doing with the addition of some of this type of exposure? Maybe you guys can talk about data and indexes in this context.

Moriarty: Sure. I’ll take a stab at the data. I think it’s going to be massively important, and I think that might surprise some people. And what I mean by that is the private-asset managers who are coming to market now to meet retail investor advisors’ needs, they might not be used to the transparency or disclosure requirements that the ETF market has made normal for a lot of investors. And so, I think being able to access that data, provide that data, and really use it from an advisor’s point of view, and really to Naz’s point, about what am I actually getting in these private assets? Am I getting venture? Am I getting buyout? being able to slice and dice and access your underlying holdings in a way that actually allows advisors to meet the needs of their clients and build the portfolio that they want to build, that will absolutely have to happen if this convergence sticks around and stays permanent. And if it doesn’t, if the data needs are not met and the transparency needs are not met, then I don’t think convergence has legs.

Tarhuni: I’d take a couple of stabs at that. On the data side, I think obviously at PitchBook, we have been primarily, over the last 17 years or so, a data and research business. And I think I would say we’ve served pre-investment up to the investment and then a bit of performance measurement post-investment. And what that allows you to do in private markets ... we just talked about, Kunal you stated the shrinkage in publicly traded businesses. Well, there are numbers out there that you can say globally in terms of private-equity-backed companies that there are hundreds of thousands, if you look at just private businesses in general, there are tens of millions of those companies.

Kapoor: For sure.

Tarhuni: So, one of the things that we see our customers do both on the credit side and private equity is, it truly is a massive effort to turn over every stone in terms of—what in the equity markets, you would call security selection, we would call company selection—of trying to identify where can you source businesses that meet a certain criteria that allow you to generate alpha. And I always like to say our clients are really in the information business. They’re always looking for asymmetric information that allows them to make a decision that ultimately would generate a return. And so, I don’t think that goes away, particularly as you have specific funds that might target some of the retail and the wealth channels, I think the security selection, the company selection, and the requirements may become even more rigid in order to guarantee capital preservation and returns. And so, from there, the ability to have massive datasets where you can source information, you can understand the revenue implications, the EBITDA implications, the value-creation implications, I think that’s something that will continue to power and something that we think about consistently.

In terms of indexing and benchmarking returns, I think we talked about it earlier, I’ll start with the credit side. Typically, you’re benchmarking private credit on, don’t lose my money and give me the spread that you’ve guaranteed. I think in a world where you might have additional market makers, and the paper might start to trade a little bit more active, similar to what you see in the broadly syndicated loan market, well then for advisors, you are measuring things relative to what? And you will look for a benchmark that will try to measure that. And I think we see that, Kunal, in our own index. In the Morningstar LSTA Leveraged Loan Index, where for many loan funds and even many different types of multi-asset class funds, we are the benchmark, in the stated benchmark they are benchmarking to. And so, if the private credit markets begin to trade a little bit more, particularly given how much scale is there, I think there is a role there where that will be very necessary. And so, I do think it’s a big adoption. There tends to be friction when you’re trying to drive net new adoptions, but it’s something that is certainly top of mind for us.

Kapoor: I think on the equity side too, ultimately the big change and the way people will need to maybe think about it is this notion of what’s investable and what’s not. Traditional public equity benchmarks have always included things that are investable. I think for the CFA to call something in an index, it has to be actually investable. Whereas on the PE side, that may ultimately not end up being the case given the way the industry works at least today.

What about fees guys? A favorite topic here. There are lots of fee layers in some of these new vehicles, some of that may be stripped away, but it’s likely that fees are still likely to be higher than they are for most public offerings. And so, how do you think about that and what are some good rules of thumb here as people consider these types of investments?

Moriarty: The average fee on an interval fund was 2.5% compared to the average mutual fund fee, which was I think 90 or 99 basis points. So, the interval fund fee is more than double the average mutual fund fee. And that’s a lot. That’s kind of hard to stomach. And there are a couple of reasons for that. One is that a lot of these funds invest in their own funds. The interval fund invests in private funds that charge a high fee. And so that fee gets passed on to you, the interval fund investor.

But I think what will end up happening, and this happens every time, and this is the beauty of capital markets and capitalism, is that as more people enter this space, fees will go down because they’re competing with each other. We don’t know what the price of the Apollo and State Street ETF will be. That wasn’t in the filing. But we’ve seen more recent filings of interval funds where the fee is 1%, less than half of what the current average is. And that will continue to happen, especially as firms like Capital Group enter the interval fund market next year in a partnership with KKR. Capital Group is known for being pretty aggressive with their fees. And so, I think you will continue to see fees come down, and that will only be to the benefit of investors.

Tarhuni: I would just say, on the private side, it is an expensive asset class, but I shared some of the numbers specifically of private equity earlier, which is that it tends over time to outperform quite a bit. And so, I think it’s all relative. Are you paying for what you’re getting? I think what we’ve seen in the institutional market is adjusted structures where institutions are able to co-invest, are they able to write bigger checks earlier on for fee breaks, and that’s helpful. There’s a level of information and transparency. There are secondary markets that have developed and have scaled at a level that we haven’t seen really ever over the last three, four years that have provided more liquidity for institutions. And so, I think in general, I don’t see adjusted structures on the institutional side. And so, I think what these firms will start doing is they’ll accept the lower fee for a lot more volume from retail and wealth channels, but I think they’ll maintain their fee structures on the institutional side, and that’s how they’ll make it pencil.

Kapoor: That’s an interesting point, actually, and I think a good way of differentiation. Your comment is interesting, too, just about the added value. I think if I go back and look at the public markets, it was often the argument that people could charge more for less liquid areas, and obviously that has whittled away in time. And so, we’ll see if that can persist here as well given some of the trends we’re seeing. We’re coming up here with just about five minutes to go, so I want to ask a couple of more questions here before we wrap it up. There are a few more coming in, and if there’s anything else our viewers would want to ask, please do send that in. But one question right now: What do you think is most important for investors who are looking at these and deciding if they should add them to their portfolio? What advice would you give them if there are two or three things that you’d say focus on?

Moriarty: I would say you have to ask yourself, can you live with the lack of liquidity? Is my financial position, my financial wherewithal such that I can handle this money getting stuck for a while?

Kapoor: With the ETF, that won’t be an issue though.

Moriarty: Hopefully not, yes, correct. And is it worth it after fees, right? It might be too expensive to stomach, we just talked about this. But you need to ask yourselves those questions. Can I meet my needs? Another way of thinking about it, is can I meet my financial goals without access to privates? Or is access to privates really giving me a unique return stream, retirement income, access to markets, and access to the investable universe that I need access to if I’m a broad market investor? If it’s meeting those needs and you’re doing it at the cost that you find acceptable, then it might be a good idea. But if it’s not, if there’s something about that that you either don’t need or can’t stomach, you don’t have to force yourself.

Kapoor: Right.

Tarhuni: What I would say is, I think what’s interesting is, I think sometimes the construct of how some of these private—let’s just use credit as an example because I think that’s where we’re seeing the most innovation right now—if you think about the construct of a true private credit fund or a structured product like a CLO vehicle, I think, yes, there might be a high minimum, but you tend to end up in a vehicle that is part of a wider pool. So, if there’s been five funds raised in a private credit vehicle, many of the middle market actually put them all in the same pool, and you have access to the coupons that are being paid from the entire portfolio, and you are typically getting liquidity every single quarter from the coupon payments. And then there’s typically only a three- or four-year period before you can start to see redemptions of your capital. And so, with that, you tend to get higher returns, and that’s where you’re seeing your total returns today in some of these funds at 12%, 13%.

If you think that being in a hybrid vehicle where you need to get in and out is going to generate enough of a return for you that it’s worth it, then I think you can consider that. But the reality is it is not a pure substitute for pure private credit. It is definitely a hybrid approach that will come with less return. And I think you should try to pencil that out.

Kapoor: Some of the skepticism from our viewers is around what might happen in a crisis when some of these products that hold private assets in a liquid wrapper have to operate in a way that they’re not used to. And so, I think that’ll be something to watch.

Final question for you guys. A little bit personal. I didn’t prep you for this one. Are you personally looking at investing in any of these, and are you excited by what’s happening in this space yourself for your portfolios?

Tarhuni: I mean, full disclosure, I am currently a traditionalist, invested in traditional vehicles that I do believe in on the private credit side. And I think I’m a bit skeptical to see what the return profiles really look like from these funds.

Kapoor: Brian?

Moriarty: They’re at the bottom of my waterfall between saving for retirement and investing in 529s for my two kids. So, if there’s any money left over after that, then yeah, I would think about it, especially for, if we’re getting access to, for example, asset-backed lending is something I find pretty interesting.

Tarhuni: I think one thing I’d add is what I’m actually most interested in, Kunal, is the ability to take our illiquid assets like our retirement and our saving, and our ability to put them in more of the traditional private vehicles have done well over time. I can’t go tap my 401(k) every day. And so, I don’t need the liquidity there. I would love the ability to be able to allocate that into some of these vehicles.

Kapoor: And I think that’s what you’re seeing with the Cap Group/KKR opportunity, for example, and what they’re trying to do. So, thanks guys. It’s been a great conversation. We’re going to have a lot more to say on this, a lot more data and indexes to provide on this. And yes, to the person who asked if this is going to show up in their X-Ray analytics, that is the plan. And so, thanks everybody for joining us. And Brian and Naz, thanks in particular, it’s been a great conversation. See you all next time.