Private Markets at an Inflection Point

0:04Pete Lyon:I think we're in the middle of a market structure change, just like we had in public equity domain, where we had decimalization of equities and ETFs of equities and increased liquidity across the curve. We have a situation here in alternatives where market structures are evolving very quickly. Are private markets at an inflection point? Interest rates are elevated, liquidity is tightening, and cracks are beginning to surface, especially in private credit. So what does the shifting landscape mean for investors in private markets and for the companies that rely on them for capital? Welcome to Exchanges, the weekly show where we unpack how Goldman Sachs is making sense of the most consequential forces shaping markets and economies.

0:48Pete Lyon:I'm Alison Nathan.

0:52Pete Lyon:My guests today are Pete Lyon, Global Co-Head of the Capital Solutions Group within our global banking and markets business, and Michael Brandmeier, Global Head and CIO of the External Investing Group within Goldman Sachs Asset Management. We'll explore today's opportunities, how private capital is evolving, and the risks coming into focus. Pete, Mike, welcome to Exchanges. Thank you. Thank you. Thanks for having us. So let me start by taking a step back. When you both look across the private equity and credit markets today, what do you see as the single biggest shift in the landscape over the past 12 to 18 months?

1:29Pete Lyon:Mike, maybe you can start us off.

1:31Michael Brandmeyer:Sure. We are at a big inflection point right now, and there's certainly a lot of stuff going on. But first, let me put it into context. So if you look between 2010, right after the GFC, right through 2022, when the Fed increased interest rates, you had a period of unprecedented growth in private markets. Private markets actually over that period of time were up six times. So just a massive period of growth. Then the Fed increased interest rates and everything came to a halt. And so as we sit here today, now four years later, there are these big questions that are looming over the market. Number one is AI.

2:08Michael Brandmeyer:AI is changing everything in the investing world, as we talk about often on this podcast. In private markets, that's definitely true. Some of that is the big investments that are being made in AI and a lot of the opportunities around it and how much of private equity is invested in software over the last period of time. It's about 30%. But there's a lot of questions, what is going to happen to that exposure? So that's number one. Number two is private markets have been doing great over that period of time, but public markets have been absolutely ripping, investing, particularly in the last two years.

2:40Michael Brandmeyer:And so people are asking the question, gosh, is the illiquidity premium there? Is it worth it to be investing in private equity when I can just invest in public markets? So that's another question that I'm sure we'll get into. And then finally, we talked about the cracks, the distributions. Distributions are sort of a circulatory system of private equity. It's the way that the whole things work. You lock up your money on average, you think that in five to six years, you're going to get your money back with a multiple. Maybe it's going to be one and a half. Maybe it's going to be two. Maybe it's going to be three times, or in some cases, more or less.

3:14Michael Brandmeyer:But the average time of holding companies has gone up a lot. The average time to IPO for venture company right now is 14 years, right? It's a long period. And these are for the big winners, the companies are going to go public. In private equity, it was five and a half years, just going back maybe five and 10 years ago. Now, the average buyout is being held for almost seven years. So the system is gummed up. The circulatory system is not working. And so that's making fundraising harder. It's driving consolidation. It's driving a lot of change in the industry. So we are definitely an inflection point.

3:49Michael Brandmeyer:And I haven't even touched on what's going on in private credit.

3:52Pete Lyon:So maybe I'll build a little bit, Allison, on what Mike has said, even taking a further step back. I think we're in the middle of a market structure change, just like we had in public equity domain, where we had decimalization of equities and ETFs of equities and increased liquidity across the curve, we have a situation here in alternatives where market structures are evolving very quickly. And I think to your question, we are at an inflection point. I think if you look at private credit, for example, it's been much maligned and depressed in certain aspects of it. But if you look at any historical averages in terms of defaults and underperformance in private credit, we're really nowhere close to even those averages, either in private credit or in public credit.

4:34Pete Lyon:And there are certain aspects of private credit, whether it's in software-centric companies or companies that were over-levered coming out of the 21-22 LBO period that are a bit softer in performance. But really, private credit holistically is a very solid asset class. And if you look back to the GFC and prior business cycles, you had default rates exceeding 10%. Today, they're at 2 % or below, depending on what subcategory of private credit you're looking at. And even in a very stressed scenario where you had 50 % plus of private credit underperforming, if you look at that over history in a 10 % default rate, you still only got 5 % of losses versus a up to top to bottom and a peak to trough in the equity market was over 50 % during that same period.

5:19Pete Lyon:So private credit is a very resilient asset class. And I think there are aspects of it, as Mike alluded to, that will go under pressure as the economy strains a bit. If that does happen Right now, we're in a pretty resilient period, but we think it's a good asset class to be in, and that will persist. And if you look at private equity, as Mike said, we're a little bit of an indigestion period, if you will. We've had the luxury over prior cycles of much shorter hold periods and investment gains that were driven by lifts in multiples. And now we have a market that's elongated, and we think what's happening is things are really going to return to historical norms as it relates to holding periods, call it six, seven years.

5:56Pete Lyon:And if you look at distributions as a percent of in the ground NAV, those have been historically low. Mike and I will go through those, but we think those will return to normalized levels of 15 to 20 percent. But it's going to take some time. And I think AI is going to be a big factor in the context of all that and how that plays out both upside and downside across portfolios is being discussed today. But I think if you look at equity monetizations on the private equity side of things, it's been slower, but we're starting to see the waves lap up on the beach with higher frequency Now, we don't think there's going to be tsunami of distributions.

6:28Pete Lyon:We think it's going to be more consistent as the market continues to perform. But that's a big if, right? Right. So we are not particularly worried about private credit as an asset class. But let's talk a little bit more and dig in on that private equity side. So what will be the catalyst, not for a tsunami, but to see normalization in that area?

6:48Michael Brandmeyer:So let's talk about why are we in this period of indigestion right now? Why is the circulatory system not working? It's relatively simple, and it just goes back to the math of private equity. If you go back to 2022 after that period of massive growth, what happened? The economy didn't go into recession. Capital markets were open. There was plenty of dry powder. Pete said, on average, about 20 % of market value realizes on average every year. So why have we been stuck down to 8%, 9%, 10 % over the last three years? Well, the reason is relatively simple. the Fed increased rates by roughly 500 basis points.

7:23Michael Brandmeyer:And private market portfolios weren't really marked down that much. And so if you do the math, remember, this is a levered asset class, where usually you take about one part of equity and one part of debt to finance the buyout of a company. If that debt gets a lot more expensive, that asset is actually worth less. And so the private equity portfolios were worth less, but the marks were slow to come down. What's happened to change that. A couple of things have happened. The economy has been strong. So we've had three to four years of economic growth. That means the underlying operating earnings of these companies have continued to grow.

8:01Michael Brandmeyer:Number two, debt prices have eased a little bit now since the Iran war and the inflation worries. Rates are back up a little bit. But in general, rates have been coming in. And now there's this intense pressure that GPs are feeling because the LPs are clamoring to have distributions. And frankly, they're saying, we're not going to go into your next fund until you've returned more money from this last fund in the fund before that. So those things are combining to create an environment. But for the Iran war, we think that 2026 was setting up to be a great year. When I talked to my colleagues in investment banking and Pete's area and others, we look at the number of mandates that we have as a firm.

8:44Michael Brandmeyer:It's very considerable. If you look at the IPO backlog. It's been growing for a number of months now. And so we think that the market is really poised for a relatively strong period of distributions. And then also you have secondaries. Private equity secondaries is something that has really come up over the last decade, and that's providing an escape valve as well. And so when you add together these conditions, we think the setup for things to normalize over the next one, two, three years is very strong with all the geopolitical and economic caveats notwithstanding.

9:17Pete Lyon:Right. And of course, the pressure on rates, which has not been what we all expected to see, at least at this point, because as you said, primarily because of the war. But when we think about how the sponsors are actually dealing with some of this and some things going in the right direction and some things not going as well as I think we had expected, how are you seeing them adjust? Are they putting more equity? Are they getting more creative about their structures? Are they just walking away from deals? Or is it just wait and see? Maybe I'll take a swing at that, Allison. And Mike, you could jump in here.

9:51Pete Lyon:I would say the sponsor community is not to be underestimated. This is a very experienced and creative crowd. And I would say outside of the normal course M &A processes that we see, the ability, and Mike alluded to this, to find liquidity across the capital structure has become increasingly more acute. And you think about the monetization paths that sponsors have. Years ago, it was just IPOs and M &A, sell-side M &A and IPOs. Those are still readily available, but you think about the liquidity spectrum, whether it's NAV-based lending, whether it's cash flow-based lending against the GP, whether it's secondaries, whether it's structured transactions.

10:26Pete Lyon:The world is awash with liquidity right now. And the sponsors realize that. They have a lot of liquidity built up in their system to invest in new companies, but there's also a lot of liquidity on the buy side ready to invest in their companies. We have a functioning IPO market now. We have a leveraged buyout market that's been incredibly slow. There hasn't been a lot of supply because of this mismatch between sellers and buyers, but capital is actually starting to grow into some of the market multiples now. And so, as I alluded to earlier, I think you're going to see more liquidity across sponsor portfolios.

10:56Pete Lyon:This DPI phenomenon, or said more simply, the return of capital to investors will improve over time, but it's going to be over a period of time. This is not going to be an overnight sensation. But right now we have a very constructive macro backdrop. And surprise, surprise, the sponsors are running into it. So I would not underestimate their ability to create liquidity events for their limited partners.

11:17Michael Brandmeyer:The one thing I would add to that is we have a strong bias toward GPs that add a lot of value. And so as Pete said, I wouldn't underestimate GPs because it's been a difficult time. They've had to contend with a difficult geopolitical and economic backdrop. but the capability to add value to these companies. The magic of private equity is you have concentrated ownership among an ownership group that has deep domain expertise and operating expertise. So they have not been sitting on their hands. They've been doing a lot with these assets and we think that they're gonna drive value over time.

11:49Pete Lyon:But as you said earlier, Mike, you've got these private markets. We have reason to believe that there's going to be more normalization ahead. But at the end of the day, the public markets are accelerating very dramatically, as you said, new highs, new highs, new highs. So why private market versus public market in that context?

12:12Michael Brandmeyer:Yeah, we're getting this question a lot these days. I even get it sometimes at cocktail parties. Should I still be having this allocation to private equity? And as a matter of fact, when you look at three-year rolling returns, private equity has actually gone negative in terms of alpha to the public markets for the first time over the last two years. And so just to explain what we do is we take a portfolio of private assets and public assets, and we match up the buy and the sell dates to determine what is the direct alpha of holding a private equity portfolio. What we did is we looked at periods of return when returns in the public markets were negative, when they were zero to 10%, and when they were 10 % and above.

12:52Michael Brandmeyer:And what you tend to see because of the marking convention of private equity tends to be more smoothed over time, is private equity is roughly flat when public markets are up more than 10%. And you see a lot of the alpha in more normal return environments, so zero to 10. And you see a lot of private equity outperformance, dramatic outperformance when public markets are negative. And so we're confident that over time, I mean, last two years, one of the reasons why private equity doesn't look so grade as public markets were up between 40 and 50 percent over that period of time. The marks are smoothed over time.

13:28Michael Brandmeyer:And as you see things normalize, we're confident that alpha is going to be back in the historic ranges where we've seen it.

13:35Pete Lyon:And also, Alison, I think you have to consider to build on what Mike said. The dispersion of the public markets is very high, right? So while the public markets are up, it's very concentrated in terms of what's driving that alpha, whereas a typical diversified private equity portfolio, unless it's specifically concentrated in a subsector of the economy, which some are, you will see that outperformance over a longer hold period. So we still think, A, the asset class has durability and running room, and B, has a real place in global portfolio allocation. It's just this recent period of time where you've seen these big dispersions.

14:04Pete Lyon:And that has proved true historically through some of the data when you see a big outperformance in the public markets vis-a-vis the private markets. Right. But as an investor, shouldn't you be paid more overtime in the private markets because they're less liquid. You should be receiving an illiquidity premium, shouldn't you? Yeah, that's right. And Mike, you've probably measured the data more specifically, but historically, some of those illiquidity premiums have gotten as high as 1 ,200 points versus the public markets. I think that has compressed lately. But if you look at long period averages, I think you still get paid the illiquidity premium in the private markets.

14:37Pete Lyon:But Mike, you might want to comment across the data that you see.

14:40Michael Brandmeyer:Well, I think a way of summarizing some of this conversation is to say that actually alpha is cyclical in the private markets. And that's because private equity is a levered asset class. It is pro-cyclical. So that is an underlying fact of private markets. But you also have, as Pete said, a lot of volatility and variability in public market returns over time. And so you do tend to see this. Now, when you look over that 25 or 30 year period of time that I referenced, it tends to even itself out. And I think most academics would say if you're getting one to one and a half points of an illiquidity premium, that's very much worth it for a portfolio that's diversified across assets.

15:18Right.

15:19Pete Lyon:So, Mike, if you look ahead, where do you see the most compelling growth opportunities in the private markets over, let's say, three to five years?

15:26Michael Brandmeyer:So I think there's a couple of areas that I would highlight. Number one is, if you look at the whole innovation economy, that is really happening in the private markets. I talked about the average company taking 14 years to go public. The reason for that is, You don't need to go to the public markets to raise money. There is massive amounts of capital available if you want to grow a company. Contrast that with Amazon. They went public in 1997 because they needed to raise$54 million, right? So in other words, if you go back to that period of time, you couldn't raise more than $54 million in the private markets.

16:06Michael Brandmeyer:Now you've got people raising tens of billions of dollars. So the only reason that you're really going to go public in most cases is because you need to provide monetization to your early investors and to your employees. And so that means that most of the innovation out there in terms of new companies is going to live in the private markets. I don't see that changing, honestly. And that's a trend that has long-term links. That's number one. Number two, other forms of liquidity have really become much, much more important in today's market. Pete talked a little bit about hybrid capital and different forms of financing, but the secondary market has become really big over a period of time.

16:47Michael Brandmeyer:It was about$250 billion last year. We estimate that over the next three to five years, the secondary market could be as big as$500 billion. So there are other forms of liquidity, and this is a very creative market. It does evolve quickly and new solutions come up. This is a great example where we're seeing more and more instruments come up that are creating liquidity for investors in markets. The third thing I would say that's going to continue to grow is retail. So if you look at these returns, if you look at what I'm talking about, what's happening in the innovation economy, I think a lot of people are saying, should we prevent all retails except for the wealthiest investors from participating in these different premia that you see in these markets?

17:30Michael Brandmeyer:I think a lot of people are saying, no, we should democratize that. We should open that up to more people. We agree with that with a big but. There need to be guardrails. There need to be education. And so we are fans of opening up access to alternatives. We are providing solutions to our own investors. We are working with other firms on what they're doing in the evergreen space. But this is a trend, notwithstanding what's happening in private credit, that we believe is going to continue over the next decade and probably decades.

18:02Pete Lyon:Pete, can you talk a little bit more about that on the private credit side? Because the retail participation has been what's been in focus on private credit and a source of concern. Yeah, if you look back over the last five, six years, retail participation in private credit has compounded every year 60%. And it's right now about 20 % of the private credit market is held and writ large in retail. And that was fine until there was a liquidity mismatch between those who were the investors in the funds and those who managed the funds. And part of that, as I alluded to earlier, is a conflation in the press between what is actually a systemic credit problem and what is not.

18:39Pete Lyon:And we don't believe that there is a systemic credit problem in the private credit industry or in credit generally right now because of the performance in the economy. But I do think that, as Mike alluded to, it's important that the investors understand the nature of the underlying vehicles that they're invested in, i.e. if there's a 5 % liquidity provision, there's a reason for that because these assets are liquid. They're supposed to be illiquid. Now, there is a burgeoning private credit trading aspect coming into the market, so it'll be interesting to see what becomes a private credit versus a public credit over time as private credit becomes traded and more liquid.

19:11Pete Lyon:But right now, the retail participation in those vehicles has ebbed, not surprisingly, because when investors want their liquidity, it's not fully available on the day they want it. And so I think that is now better understood. As Mike alluded to, I think that was broadly an education point rather than was a feature of these funds to be illiquid and to have these gates. But I don't think that was well understood enough. And that's why we've had a lot of the press around it. But as you look at the broad credit cycle right now, if you look at portfolio quality, if you look at default rates, if you look at pick rates, all the key things that people look to in terms of the underlying performance, it's actually quite good.