How transactions will evolve

Wider access and louder demands for transparency mean the nature of transacting in private markets will change. Investors are already asking questions that extend far beyond their traditional focus on operations, process, and controls. Additional lines of questioning are likely to cover topics ranging from valuations and diversity to the environment, technology, and cybersecurity.13 The extra diligence is often aimed at fund CFOs, creating a potentially unsustainably high workload.

Environmental, social, and governance (ESG) issues are becoming more prominent, leaving managers scrambling to adapt and creating the potential for turnover as investors attempt to restructure portfolios to better align with their values. With investors actively seeking ESG screens and a more diverse slate of portfolio managers, GPs are being forced to step up. Invesco’s Scott Baskind notes that “our global institutional investor base increasingly is demanding ESG to be fully integrated into private asset classes. From our perspective, ESG is a central tenet to our credit risk evaluation and an area we moved on years ago to develop a proprietary framework to appropriately underwrite the risk.”

Brian Bank, of the Investment Funds Group at Kirkland & Ellis, says his firm is now seeing more strategies around the Social and Governance side of ESG. He goes on to caution that “ESG is still somewhat of a challenge in practice. There need to be clearer, more succinct definitions by GPs so that LPs know where to bucket their allocations accordingly in terms of addressing ESG and incorporating it into their investment strategies.”

Lest this trend be dismissed as a fringe development that can safely be discounted or given lip service, it is worth considering the broader context. Taking a more holistic view toward the sustainability of assets or strategies, investors are looking beyond ESG to also ask managers about diversity and inclusion (D&I) initiatives. These queries may be aimed at establishing common philosophical ground, but they also focus on more tangible operational details like formal written guidelines. It is only a matter of time before service providers will be expected to provide similar information as part of due diligence, further enhancing transparency and setting the stage for additional liquidity in the market.

These developments mean new approaches are needed, and advances in technology and data science mean there will almost certainly be more use of trading platforms and exchanges: 68% of investors and 47% of managers expect them to gain market share (Figure 11), compared with only 10% and 16% five years ago. Both groups are also bullish on direct transactions. Technology-enabled platforms will have structural repercussions across the industry. They can, for example, make it easier to for smaller managers to compete for investors’ attention, effectively leveling the playing field. Technology can also enable greater transparency and make it easier for investors to conduct due diligence. Both sides win.14

68% of  investors and 47% of managers expect trading platforms to gain market share

“Our global institutional investor
base increasingly is demanding
ESG to be fully integrated into
private asset classes.”
--Scott Baskind,
Head of Global Private Credit, Invesco

In-house technology use is also ramping up, thanks to the repurposing of travel and entertainment budgets. According to Kirkland & Ellis’ Brian Bank, simplified scheduling means remote work has actually improved some aspects of the due diligence process for both managers and investors. Beyond sheer efficiency, he point out that this new model has encouraged “market mapping exercises as well as macro- and micro-level analysis. It is a function of ignorance not knowing what else is out there.” Scott Baskind of Invesco adds, “The current environment has the potential to interrupt any GP’s diligence efforts, but we also believe this is a time where you can derive meaningful benefits and relative edge from having a broad, fully integrated, private credit platform which incentivizes information sharing and collaboration.”

Pressing forward with packaged products

With the growing acknowledgement of a changing investor base, the need to expand packaging options is becoming clearer. There is still some skepticism around the future of private securities packaged as investment products such as mutual funds and ETFs, but approximately a third of all participants expect them to become more important features in the private market landscape (Figure 12). This is about the same level of conviction seen five years ago. What has changed more dramatically is the number of naysayers, which fell from 16% of all respondents six years ago to less than 10% today.

A majority of investors and managers expect products such as mutual funds and ETFs to become more important features in the private market landscape

Tempered expectations may be a by-product of the mixed reception to liquid alts thus far. Despite the existence of 779 open-end funds categorized as alternative by Morningstar dating as far back as 1977, the median fund balance is still only $57 million. Most of these funds exploded on the scene starting in 2005 as new and experienced managers alike crowded into the market. Yet there are currently only 41 managers who can claim more than $1 billion of assets under management in alternative mutual funds or ETFs.15

Tepid reception notwithstanding, proliferating liquid alts paved the way for this new cohort of private market funds, demonstrating that virtually any investment strategy can be packaged in novel and useful ways. Private markets, of course, present unique structural challenges that come with trying to package inherently illiquid investments in highly liquid vehicles. Regulatory hurdles set the bar even higher.

In a trickle that may preface an eventual flood, a few managers have chosen to seize the initiative and design private market products for the retail market. Much of their effort has focused on ’40 Act funds that can offer private market exposure with liquidity terms and low minimums more suited to individual investors. Exposure is often a mix of direct and secondary investments, sometimes with a strong emphasis on one or the other. Secondaries are valued in this market for the same reasons they are attracting more institutional investors: Later entry can eliminate the least desirable portion of the J-curve and ultimately permit timelier exits.

Despite operating under a common regulatory framework as ’40 Act funds, these products can differ substantially in the details. Some, like a fund launched by Partners Group back in 2009, are structured as tender-offer funds, which give the manager some degree of control over redemptions. Others are structured as interval funds, where the redemption process is prescribed and pricing may occur daily instead of monthly.16

Portfolio Advisors’ Patrick Gerbracht lays out the case for the use of secondaries in retail products: “The private equity industry as a whole should be prudent and smart on expanding into the retail space. Secondaries, with their inherent attributes, allow retail investors to gain exposure to the alternatives space while avoiding the associated volatility with a significantly more concentrated portfolio like a traditional buyout or venture fund. The demand for increased alternative exposure is real and should serve as an enormous growth area for secondaries private equity in the years to come.”

On-chain securitization aims to revolutionize how private markets are traded.

Mutual funds and ETFs will almost certainly play a key role in allowing mass affluent investors to access private markets either directly or via their advisors, but they may assume other forms as well. Offering steady flows and sticky assets, 401(k) plans are a plum prize for any manager targeting the retail market. As a heavily intermediated market, retirement plans will expect products to be adapted to their needs rather than the other way around. As a result, private market strategies may need to be packaged in CITs and embedded in target date funds (TDF) to succeed.

Is there a role for decentralized finance?

Exchanges or marketplaces for private equity and debt are relatively new concepts that rely heavily on technology for successful implementation. Still, they are modeled on well-established models for securities exchanges that date back centuries. More radical disruption could be around the corner, as a rapidly growing blockchain-based ecosystem awaits to facilitate trading and investing in a novel way.

Distributed ledger technology offers the promise of doing things very differently than the past. Even as many remain fixated on the gyrations of cryptocurrency prices, Ethereum-based decentralized finance—colloquially known as DeFi—is quietly flourishing. Tokens and protocols have mushroomed, thanks in no small part to the built-in security and simplicity allowed by embedded smart contracts. Most of this ecosystem is entirely digital and linking it to real-world assets via tokenization is still a small part of the overall picture. It is not even clear that existing DeFi protocols will ultimately survive. In the meantime, however, they are collectively demonstrating an effective proof of concept.

Existing users or boosters of DeFi may be bullish on this model, but the private market managers and investors in our survey are more circumspect. Only 14% of managers expect tokenized assets to be traded in any meaningful way using distributed ledger technology within the next five years (Figure 13). Investors are more optimistic than managers, but most expect it to remain a fringe activity.

FIGURE 13. What is your view on the trading of tokenized assets using distributed ledger technology? 36% of investors and 24% of managers feel it's attractive but will remain niche for the foreseeable future, while 33% of investors and 43% of managers don't know enough about the it to comment.

Will it ever amount to more? Thanks to multi-million-dollar sums being paid for sometimes questionable digital artwork, everyone is now familiar with non-fungible tokens (NFTs). Less commonly known is the fact that NFTs can be linked to physical assets such as oil paintings. This simple idea shines a light on a parallel ecosystem that has largely gone unheralded, where on-chain securitization aims to revolutionize how private markets are traded.

Tokeny, which claims to be “driving liquidity in private markets,” confidently states that any financial asset can be tokenized. The company articulates use cases for private equity, debt, and real estate while promoting their platform as a way to “issue, manage, and transfer private market securities on a hyper-efficient infrastructure.”17 The jury is still out on the near-term prospects of DeFi and tokenization, but given the potential for radical disruption, managers and investors will want to monitor developments in this area.

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Legal Note

The Investment Manager Services division is an internal business unit of SEI Investments Company. This information is provided for education purposes only and is not intended to provide legal or investment advice. SEI does not claim responsibility for the accuracy or reliability of the data provided. Information provided by SEI Global Services, Inc.

13 Apperio, Seven Strategic Private Equity Business Trends to Watch in 2021, November 2020.
14 Private Equity Wire, “Technology Can Counter Investor Conservatism,” October 22, 2020.
15 Simfund database, ISS Market Intelligence, March 31, 2021.
16 Alex Lynn, Complex ’40 Act Funds Help Democratise PE, Private Equity International, March 15, 2021.
17 Tokeny Solutions, What To Tokenize, https://tokeny.com/what-to-tokenize/