Are listed stocks or unlisted funds the better 'alternative'?

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Investing in listed Private Market manager stocks is significantly different from investing directly in Private Assets. But are the stocks of private market managers a better investment than their unlisted funds? And is investing in a private market manager's stock a viable substitute for investing in a private markets fund? We take a look at those questions, as well as offer our top picks, in this wire.

Background

Private Markets are debt and equity investments in private companies or assets, such as Private Credit/Debt, Private Equity and Real Assets including infrastructure and real estate.

Between 2000 and 2023, the number of publicly traded US companies declined by more than 30%. Conversely, over the same timeframe, the number of private US companies backed by private equity firms grew by more than 500%. 

Figure 3: Private Equity-backed versus publicly listed US companies

As access to investment capital has grown, companies are choosing to stay private longer, reflecting a mentality that has become commonplace in Silicon Valley and elsewhere. For example, Uber Technologies (NASDAQ: UBER) and Airbnb (NASDAQ: ABNB), two of the largest technology initial public offerings (IPOs) ever, remained private for 10 and 12 years respectively before listing. 

The appeal of private markets

Key Private Investment strategies have meaningfully outperformed the Russell 2000 Index over the past 3-, 5-, 10-, 15- and 20-year periods.

Figure 5: Venture Capital and Buyout/Growth Strategies have outperformed public markets

For high-net-worth investors with a tolerance for illiquidity, Private investments - including Private Equity, Credit and Real Estate - can be efficient sources of return, generally providing a premium over their public market counterparts and access to companies that may not be available to the typical public market investor. 

It is not uncommon for an ultra-high-net-worth client today to allocate between 16%-24% of their portfolio to Private Investments. Similarly, endowments and other institutional investors often hold between 10%-25% of their portfolio in Private Investments.

For us at Morgan Stanley, we continue to raise our allocation to Alternatives across our Core+ profiles. Most profiles have adopted a neutral Alternatives allocation of around 23% versus around 20% in our prior published SAA.

• Within our defensive assets' allocation, persistent high cash rates and solid corporate balance sheets make Private Debt the most attractive asset class in absolute and relative terms.
• Within our growth assets’ allocation, equities will likely face some headwinds despite a promising CAPEX cycle ahead - including mildly expensive valuations and the risk of a recession in the next seven-year cycle. In addition, we expect higher rates and less accommodative central banks to keep volatility more elevated. 

In this context, most alternative asset classes offer an appealing option, whether from an absolute or risk-adjusted basis. 

The risks prospective investors must consider

• A wide range of potential outcomes: Private Investments present several initial hurdles for investors. In addition to lesser transparency, liquidity and accessibility than traditional asset classes, these investments show much greater dispersion in their return and risk profiles, at both a strategy and manager level.
• (Much) higher fees versus long-only active funds: The management fee typically ranges from 1.5% to 2.5% paid on committed capital. There is also a carried interest, which is a share of any profits that the General Partner (GP) receives as compensation, which typically ranges between 10% and 20%, and is paid as soon as and as long as the cumulative realised return from the fund’s inception to date exceeds the hurdle rate.
• Complexity risk: Complexity is particularly prevalent in asset-based lending and structured credit. These forms of Private Credit require deep due diligence and an understanding of the underlying collateral and risk profiles of the structure’s tranches. For Private Equity, there isn’t a standardised mandated level of company reporting which adds layers of complexity. 

Manager experience and sector expertise are necessary in constraining complexity risk, particularly in operationally intensive deals. However, investors can potentially earn a premium as compensation for complexity.

Figure 9: The Illiquidity premium can potentially be a benefit

• Illiquidity risk: Some funds will have a long-term lock-up period (from five to 15 years). For funds offering partial liquidity, investors might find that extreme events, such as the GFC or the COVID crisis, can result in a fund widening sell spreads or limiting the number of withdrawals. Another risk, similar to what was experienced in 2022, is a slower deal-making and exit environment in Private Equity, which in turn slows the associated distributions. 
• Market risk: Market factors that are either strategy-specific or broad can impact longer-dated funds, just as they do more conventional liquid funds, resulting in an illiquidity premium that is not always constant. 

Figure 10: During years when the public equity markets strongly declined, Private Equity and Venture Capital almost always outperformed, although they did record negative absolute performance in most cases

Private Equity: Stocks vs Funds

Why wouldn’t investors simply invest in the managers themselves – what are the benefits and drawbacks of this approach?

1) Both listed and unlisted Private Equity - as buy-and-hold investments - have been outperforming the broader listed equity market since index inception in 2000, with the S&P Listed Private Equity Index outperforming Global listed equities by 1.3% p.a.

However, unlisted Private Equity outperformance has been even better, as it has more than doubled the MSCI ACWI ex-Australia Index performance over this period (12.3% versus 6.1% respectively).

2) The risk profiles are very different. The S&P Listed Private Equity Index has the highest volatility (25.5%) of all the market segments surveyed over this period, while the Cambridge Private Equity Index has the lowest (10.9%). It is also worth highlighting that drawdowns of the S&P Listed Private Equity Index are significant.

Figure 15: Listed Private Managers’ stocks have had deeper drawdowns than MSCI World Index

3) Investors have been provided with a similar risk/return trade-off, and the higher risk inherent to listed Private Equity has transformed into higher relative returns.

4) On the positive side, we note that the S&P Listed Private Equity Index has offered higher upside than downside capture versus Global Equities, Financials and Small Caps. However, once again, the metrics are overall more favourable to unlisted Private Equity.

Therefore, based on the above analysis, owing to the leverage, volatility and skewness of returns, investing through a Private Equity fund is preferable to investments in listed Private Equity indices from a portfolio construction standpoint given this type of investment can essentially improve the risk/return profile of a portfolio.

How to evaluate a private market manager as a stock picker

On aggregate, we do not believe listed Private Equity is a good substitute for unlisted Private Market Alternative investments in diversified portfolios. However,  this doesn’t mean listed Private Market managers cannot add substantial value as a ‘portfolio tilt’ within the equities component of a portfolio. 

Figure 18: We forecast Private Market Managers to generate stronger asset under management growth and higher fees

Here is what underpins our bullish narrative on private market stocks:

1) First and foremost, from an investment outlook standpoint, the alternative asset manager industry is standing on solid fundamentals.

• Almost 90% of US firms with revenue >US$100m are private in the US.
• There is currently around triple the number of Private Equity-backed businesses than public companies in the US (see Figure 3).
• Over US$14 trillion of private capital is compounding at a double-digit pace.

2) We believe the rise of Private Markets and their increasing influence over public markets will be an enduring theme. In particular, we see the Asset Management industry as a key beneficiary of the ‘Ageing’ - or rather ‘Longevity’ - theme. Morgan Stanley estimates a US$400 billion incremental revenue opportunity for wealth and asset managers by 2028. 

Figure 20: We see a strong increase in revenues for the Private Markets in the medium term

3) Whilst valuations are elevated, we remain constructive in the short term as well, amid capital markets’ resurgence. Improving deal activity will likely see Private Markets asset managers ‘flywheel spinning faster’ via accelerating deployment of large dry powder levels, which in turn supports management fees and also asset realisations. We expect this to drive performance fees higher and increase distributions to listed Private Equity clients.

However, it is important to be selective among the Alternative asset managers’ stocks, particularly given the current 2x premium valuation relative to history. Valuations across the group suggest a high bar for earnings and reflect significant optimism. 

Figure 24: Alternative managers are no longer trading at a discount to the broad US equities market

From a fundamental standpoint, Morgan Stanley prefers Alternative asset managers ranking well on 1) solutions capabilities, 2) Alternative asset capabilities, 3) insurance/annuity offerings, and 4) wealth distribution capabilities, including the US 401k/retirement channel and private wealth channel.

Our key picks (Funds and stocks)

• Ares Diversified Credit Fund: The Fund is our preferred Global Private Credit strategy as it benefits from Ares’ substantial scale and deal flow in Private Debt markets, a well-resourced team of seasoned Private Credit investors, and a robust investment process, including a quantitative and proprietary approach to portfolio construction
• KKR Private Equity (K-PRIME) Fund: K-PRIME Fund provides direct access to all KKR private equity investment opportunities of mainly core and traditional buyout strategies without many of the limitations of direct investing. The resources and capability of the firm provide complete support from deal origination, execution, portfolio construction and risk management.
• Blackstone (NYSE: BX): Morgan Stanley sees BX as an under-appreciated beneficiary of an improved macro backdrop, capital markets recovery, and rise of retail, private credit/insurance and AI. Across the platform, investment activity is accelerating and US$170 billion of dry powder yields significant purchasing power to navigate and invest through attractive opportunities.
• TPG (NASDAQ: TPG): Morgan Stanley sees meaningful growth ahead as significant secular tailwinds and strong management execution underpins our growth outlook for +16% / +24% FRE and +31% / +23% EPS growth y/y in 2025 and 2026. We see a high-quality, capital-light business model that offers an attractive way to play the secular growth in private markets and the ongoing capital markets activity rebound.
• CVC Capital Partners (AMS: CVC): CVC was recently added to Morgan Stanley’s Financials' Finest list given its higher skew to carry recovery as activity continues to improve. The declining rate path and more supportive capital markets environment should benefit CVC more, driving approximately 25% earnings 2024-26e CAGR, at the upper end of global peers. 
• VanEck Global Listed Private Equity ETF (ASX: GPEQ): This ETF aims to track the performance of the LPX 50 TR AUD Index, a market capitalisation-weighted index providing exposure to a portfolio of the 50 largest and most liquid global listed Private Equity companies. 

You can read the full 17-page paper by downloading the PDF that is attached to this wire.

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