Ah, the good old days, when most investors could feel secure with a garden variety portfolio of publicly traded stocks, bonds and mutual funds. Suddenly, these traditional portfolios don’t feel so adequate.
Persistent economic uncertainty, changing interest rates, market volatility, and concerns about long-term returns have pushed many investors to look beyond publicly traded securities for growth opportunities. Increasingly, that search is leading to private markets.
Private equity, private credit, real estate, infrastructure, and other privately held investments have become an increasingly important part of diversified portfolios. Once largely the domain of pension funds, endowments, and institutional investors, private-market strategies are attracting greater attention from business owners, high-net-worth individuals, and other higher-tier investors.
The appeal isn’t simply that private investments are exclusive or limited opportunities. In the current economic climate, private markets have other practical characteristics that can make them particularly attractive.
What are private markets?
Private markets comprise investments that aren’t traded on public exchanges like the New York Stock Exchange or Nasdaq.
The category includes a wide range of assets and strategies, such as:
- Private equity, or ownership stakes in privately held companies
- Private credit, in which investors provide financing outside traditional public bond markets
- Venture capital, which provides capital to early-stage and growing businesses
- Private real estate, including commercial, residential, industrial, and specialty properties
- Infrastructure, such as energy, transportation, utilities, and digital infrastructure
These investments greatly vary in their risk levels, return potential, liquidity, and tax liabilities. However, they share an important distinction: their value isn’t continuously determined by trading on a public exchange.
That difference can create both opportunities and downsides for investors.
Diversification
Not putting all your eggs in one basket is one of the fundamental principles of portfolio management. Yet simply owning more publicly traded securities doesn’t necessarily provide meaningful diversification; it’s just having more deck chairs on the same ship.
During periods of economic stress, movement among publicly traded assets can begin to fall into lockstep. Stocks that react very differently during typical market conditions may move in the same direction when investors react to inflation, interest-rate changes, geopolitical events, or recession concerns. Private assets may behave differently from traditional publicly traded investments in those situations.
For example, an investor might hold shares in public companies while also investing in privately owned businesses, commercial real estate, infrastructure projects, or private loans. Each investment has different economic drivers and risk characteristics. Private markets don’t eliminate portfolio risk, but they can broaden the chance for returns when markets are questionable.
Private credit
One of the most significant developments in private markets has been the growth of private credit. Private credit generally involves non-bank lenders providing loans directly to businesses. As traditional banks have become more selective about certain types of lending, private lenders have stepped in to fill the gap.
For investors, the attraction can be compelling. Many private loans carry floating interest rates, meaning the income they generate can adjust as benchmark rates change. Depending on the strategy, investors may also earn higher yields than are available from comparable traditional fixed-income investments.
For borrowers, private lenders can offer greater flexibility, customized financing structures, and faster financing than conventional channels. The result has been a rapidly expanding market connecting companies seeking capital with investors seeking income.
Obviously, this type of investment lending carries its own set of risks. Borrowers can default, loans can be difficult to sell, and investors may sacrifice liquidity. Higher return rates generally serve to offset these risks, and the combination of income potential and demand for alternative financing has made private credit an increasingly attractive opportunity for investors.
Outside the public’s vision
As vast as it is, the universe of publicly traded companies represents only a fraction of the overall economy. Many businesses remain privately held for years, and some never become public at all. That means investors who restrict their activity to public markets may be excluding themselves from a raft of lucrative companies, industries, and growth opportunities.
Private equity and venture capital can provide access to businesses much earlier in their development, before they might transition to public offering. Private-market investors may also participate more directly in areas such as data centers, renewable energy projects, warehouses, multifamily housing, private lending, and infrastructure.
Playing the long game
Public markets provide extraordinary liquidity. Investors can buy or sell many securities almost instantly. That liquidity is valuable—but it can also encourage short-term thinking. Daily price fluctuations, doom scrolling, lackluster earnings reports, and soft economic data can tempt investors to make frequent portfolio changes based on transient market conditions.
Private investments generally operate differently. Investors may commit capital for several years, giving businesses time to execute plans without worrying about daily changes in market sentiment. A private equity manager, for example, might acquire a company, improve operations, expand into new markets, make complementary acquisitions, and ultimately sell the business years later.
The lack of daily movements in valuation doesn’t mean these investments carry less risk. It simply means investors’ thinking isn’t overly influenced by daily market movements. For investors capable of accepting reduced liquidity, that longer time horizon can be appealing.
Greater influence
While public-market investors generally purchase securities and wait hands-off for management teams to produce results, private-market investors can sometimes take a more active role in driving returns.
A private equity firm might work directly with a company’s leadership to improve margins, recruit executives, strengthen financial reporting, introduce technology, pursue acquisitions, or enter new markets. Real estate investors may renovate properties, renegotiate leases, improve occupancy, or reposition assets.
In each case, returns may depend not only on broad market appreciation but also on specific actions taken to improve the underlying investment. That ability to actively influence outcomes is one reason institutional investors have historically allocated substantial capital to private markets.
A strategy for inflationary times
While bad news for consumers, inflationary pressures can be a strategic driver for private-market investors. Real assets such as real estate, infrastructure, energy, and certain natural-resource investments may offer characteristics investors find attractive during inflationary periods.
Some of these assets may generate revenues that can increase along with prices, such as commercial leases with contractual rent increases or infrastructure agreements with provisions for inflation adjustments. In other cases, some businesses may enjoy inelastic demand, the ability to pass higher costs on to customers without negatively impacting sales volumes.
None of these characteristics guarantee protection from inflation. Higher interest rates can create challenges for leveraged real estate and infrastructure investments, for example. Still, investors concerned about preserving purchasing power may value exposure to tangible assets and contractual cash flows alongside traditional financial assets.
Beware the trade-offs
Although private investments are growing in popularity, investors shouldn’t overlook their risks.
Illiquidity. This is a major consideration. Some investments may tie up capital for several years, and secondary markets for private investments can be limited.
Fees. Fees can be substantially higher than those associated with publicly traded index funds or traditional investment products.
Valuation. This is another substantial factor, because private investments don’t trade continuously. Determining fair market value can require estimates, appraisals, and judgment.
Other risks. Private investments may involve significant concentration, leverage, credit, and execution risks.
Tax and reporting complexity. Private markets can introduce additional complications in managing tax obligations. Investors may receive Schedule K-1s rather than Form 1099s. If investment income is generated in multiple states, additional filing requirements may apply. Partnership allocations, carried interest, depreciation, capital gains, passive activity rules, and unrelated business taxable income can all become factors, depending on the investment and the investor. All this complexity makes tax planning especially important.
Make tax planning part of the cost-benefit equation
For investors considering private markets, evaluating the potential return before taxes isn’t enough. Two investments producing similar economic returns can have very different after-tax outcomes.
A real estate partnership, for example, may generate depreciation deductions while the property is held but create taxable consequences when it is sold. A private equity investment may generate long-term capital gains, ordinary income, or a combination of both. Private credit may produce substantial interest income taxed at ordinary income rates. State taxation can further complicate the picture, particularly when partnerships operate across multiple jurisdictions.
Investors should understand these consequences before committing capital, not after receiving their first K-1.
Coordination among an investor’s financial and legal advisors can help identify potential tax issues, estimated-payment requirements, cash-flow needs, and planning opportunities before they become surprises. Our team is here to help you navigate the private market waters, should you decide to explore them.
The bottom line
Private markets are attracting investors in today’s economic climate because they offer something increasingly valuable: a broader earnings horizon than traditional stocks and bonds.
Private equity can provide opportunities unavailable in public markets. Private credit can offer alternative sources of income. Real estate and infrastructure can provide access to tangible assets and long-term cash flows. And private investments can allow managers to focus on long-term value creation rather than daily market movements.
But greater opportunity doesn’t necessarily mean lower risk.
Illiquidity, higher fees, valuation uncertainty, investment complexity, and tax consequences all need to be considered carefully. Private-market investments therefore tend to make the most sense as part of a thoughtfully constructed financial and tax strategy rather than simply as a reaction to volatility in public markets.
Considering a private-market investment? Before committing capital, talk with your accounting and advisory team about the potential tax consequences, reporting requirements, and how the investment fits within your broader financial plan.