The Other 99%

According to the U.S. Census Bureau, there are roughly 6 million (yes, that’s millions!) companies in the United States and less than 4,000 are public.

According to the U.S. Census Bureau,1 there are roughly 6 million (yes, that’s millions!) companies in the United States and less than 4,000 are public.

That means more than 99% of companies are private. If you peel back the layers and only look at companies with 100 or more employees that number is still staggeringly high, 97%. These are the numbers that catapulted private equity into a proper seat at the asset allocation table over 30 years ago, at least for those wealthy enough to participate (aka Qualified Purchasers). Private credit has not yet garnered the same attention, and that is surprising given what has happened in the fixed income market over the past several decades.

Historically low rates, which have been omnipresent for over a decade and declining for more than 40 years, have caused many investors to ask: Is it possible to get real yield and if so, where?

The answer to where may come if investors are willing to expand their definition of the “market.” After all, shouldn’t the “market” include more than the largest firms that raise capital in the public markets? If in the past you have only been able to access public markets, which represent only a fraction of the total businesses in the United States, wouldn’t you want to gain access to the rest?

All of our training and life experiences have taught us the benefits of pursuing a proper asset allocation, with portfolios across both major asset classes. Investors may choose to increase or decrease their equity and fixed income allocations, depending on a variety of factors such as their age and risk tolerance. The long-term reward potential of pursuing diversification across both asset classes is evident in the historical returns of the traditional 60/40 balance stock/bond portfolio, which would have provided an average annual return of 8.8% from 1926–2017.2 That said, most of us have not been around since 1926 and experienced a roller coaster of emotions while investing. Carving out an allocation to alternatives can help smooth out returns and make investing less dependent on timing the market.3

According to Preqin, a firm that provides data and intelligence on alternative assets, almost all institutions plan to keep or increase their allocation to private equity in the next year. On average, for every dollar invested in private equity, you need roughly two to three dollars in private credit to complete the investment, meaning an allocation to private equity implies an indirect allocation to private credit. 

Strategies that can provide access to the rest of the “market” are typically considered alternatives, and they are not widely used by individual investors. Retail clients currently allocate, on average, only 3%4 of their portfolios to alternatives. Institutions allocate more than 10 times that.

Given the actual “market” is 97% private, the allocation to alternatives for retail investors should be significantly larger to enable them to pursue true market returns. Now that there are structures that allow individuals to invest in private markets (e.g., interval funds), we believe the question shouldn’t be if we should invest in private credit, it should be how much can we invest?

Disclaimer: It is important for investors to consider the risks specific to investing in interval funds. These include but are not limited to certain credit risks and risk from other factors such as perceived liquidity, quality of the borrower, credit risk of counterparties and subordination of the debt. Credit instruments that are rated below investment grade (commonly referred to as “high yield” securities or “junk bonds”) are regarded as having predominantly speculative characteristics with respect to the issuer's capacity to pay interest and repay principal. Some credit instruments will have no credit rating at all. An interval fund's liquidity is limited regardless of how the fund performs and may decline unpredictably in response to overall economic conditions or credit tightening. Debt or equity securities held by an interval fund may be subordinated to substantial amounts of senior indebtedness, a significant portion of which may be unsecured. During periods of financial distress or following an insolvency, an issuer's ability to influence affairs is likely to be substantially less than that of senior creditors. Accordingly, issuers may not be able to take the steps necessary to protect fund investments in a timely manner or at all. Interval funds may be non-diversified investments which may be more susceptible to an adverse event affecting a portfolio than diversified investments and a decline in the value of that investment would cause an interval fund's overall value to decline to a greater degree.

1.Source: 2008 U.S. Census Bureau.
2.Source: Vanguard portfolio allocation models (Balanced, 60% stocks/40% bonds) as of 2017.
3.Source: Seeking Alpha, “How Have Alternatives Performed,” August 28, 2017.
4.Source: Money Management Institute, Dover Financial Research. Endowment exclude marketable alternative strategies (hedge funds, absolute return, market neutral, long/short/, 130/30, event-driven and derivatives, retail allocation excluding liquid alternatives).

This material is provided for general and educational purposes only, is not intended to provide legal or tax advice, and is not for use to avoid penalties that may be imposed under U.S. federal tax laws. Contact your attorney or other advisor regarding your specific legal, investment or tax situation. 

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