Why Hedge Funds Are Increasingly Turning To The Private Markets For Returns (2024)

Traditionally, hedge funds stuck to the public market when it came to their allocations, but a new study from Goldman GS Sachs suggests that is changing. The firm reviewed more than 100 hedge fund managers with exposure to the private markets during the second quarter.

Hedge funds dive into the private markets

Goldman Sachs notes that in the past, the capital formation process for companies has been pretty clear, with each stage having its own set of funders. Meanwhile, hedge funds focused on the public markets.

In their early stages, companies received funding from venture capital firms or angel investors. As they grew, companies received funding from later-stage VC or growth equity firms. Some companies raised a crossover round as a final step before holding an initial public offering.

Hedge funds played no role in the early funding of companies because they focused on the public markets. However, that is changing as more and more hedge funds widen their investment scope and move into the private markets.

How the market is changing

Conventional wisdom suggests that companies are staying private longer than they have in the past, but the firm found something interesting. Goldman's research indicated that the average time between founding and an IPO was nine years in 2006, but it has only increased to 10 years in 2021.

However, it did find some other changes. According to Goldman, growing companies are conducting more equity funding rounds before their IPO. In 2006, the median number of funding rounds was one, and in 2021, this number has grown to three. Companies are raising more money in the private markets as well, with the average climbing from $43 million in 2006 to $222 million in 2021. The median has increased from $30 million to $58 million.

Additionally, Goldman finds that the volume of highly-valued unicorns, private companies valued at more than $1 billion, has risen dramatically. The firm said that in 2006, there were only three unicorns, but today, there are 392 active unicorns. In the first half of this year alone, 155 companies achieved unicorn status for the first time.

More support for the private markets

There is another factor driving increased capital flows in the private market. Goldman says capital market conditions have been extremely supportive. U.S. equity and equity-linked issuances like traditional IPOs, special purpose acquisition companies (SPACs), follow-ons and converts reached a record high of $468 billion last year. Year to date, issuances have reached $337 billion, marking the largest first half ever recorded.

Traditional IPOs are also off to the fastest start to a year ever, with $58 billion in issuance across 157 IPOs. The previous year-to-date record was $43 billion across 210 IPOs in 2000. Additionally, 327 SPACs have raised $104 billion year to date.

In addition to the higher liquidity and valuation support for the private capital markets, a strong "'IPO pop' phenomenon." The firm states that its Liquid IPO basket was up 147.9% last year, indicating that access to IPOs has become even more important for performance.

Hedge funds have benefited in this respect by participating in late-stage private funding rounds. However, this phenomenon hasn't continued this year, as that Liquid IPO basket was down 7.3% for the first half of the year.

Hedge funds in search of growth

There's another reason hedge funds are diving into the private markets more and more often. Investors in alternative assets are pouring more money into private equity and venture capital and dialing back their allocations to hedge funds.

Between 2011 and 2015, assets under management in private equity and venture capital strategies, including growth equity strategies, increased $2.7 trillion or 5% annualized. Meanwhile, hedge funds and other illiquid assets under management grew at a rate of around 10% annualized.

However, starting in 2016, private equity and venture capital strategies saw their assets under management grow from $3 trillion to $4.6 trillion for a 12% annualized rate. On the other hand, hedge funds and other illiquid assets under management slowed to an annualized rate of 5% to 6%.

The one exception in this second group was private debt, which enjoyed the same 12% annualized rate as PE and VC. Within the PE and VC group, venture capital and growth equity strategies have been growing at a 15% annualized rate.

Private markets enjoyed better performance

Investors are increasingly choosing private-market options over hedge funds because they are seeking higher returns, and for the most part, the private markets have delivered. For the 10 years ending in 2020, PE and VC strategies have enjoyed an annualized return of 14.2%, marking a 3.7% premium over equities.

Private equity and venture capital have outperformed hedge funds by about two to one, as hedge funds returned 7.1% annualized over the last decade. The hedge fund managers and allocators that Goldman spoke to cited the improved performance as one of the reasons hedge funds have entered the private markets.

"As this data points out, privates have performed better over the long term. HF managers feel that pressure and so increasingly they are creating ways to earmark their capital for private investments," Lynsey Lebowitz Hughes of Duke University said via email when asked to weigh in on the Goldman study. "Some of them will do it through separate accounts or smaller, less liquid 'best ideas' funds, but most of them do it through a side pocket vehicle, which often allows them to invest up to 10% of their total AUM opportunistically."

Hedge funds are increasingly investing in the private markets

Goldman Sachs also put some hard numbers down to the trend of hedge funds boosting their investments in the private markets. In the 10 years before 2010, hedge fund managers averaged 50 private deals per year, peaking in 2007 with 117 deals. Hedge fund involvement in the private market dropped off after the Global Financial Crisis, possibly due to liquidity challenges, changing opportunity sets and the need to focus on their core business.

Between 2010 and 2015, hedge funds averaged 200 private deals a year, and the trend has continued to shift higher since then. Last year was the largest year for hedge fund involvement in the private markets, with funds participating in 753 deals worth $96 billion. Hedge funds already participated in 770 deals worth $153 billion in the first half of this year.

Lebowitz Hughes explains that another way hedge fund managers can provide investors with a "PE-like performance" is through co-invest opportunities.

"This is when a manager invites an investor to add capital alongside them to achieve greater exposure to these one-off private deals," she explained. "Some investors love getting access to these private deals that they would ordinarily not know about. Naturally, because hedge fund managers are savvy and well-networked, they often get approached with intriguing private deals, so they are well positioned to source these deals, and investors know it. Therefore, they are keen to receive these calls and will often tell their managers proactively that they are interested in co-invest opportunities as they arise."

One thing for investors to keep in mind

Lebowitz Hughes also notes that hedge fund investors should keep something else in mind when it comes to investing in the private markets via hedge funds.

"Of course, it's still very important to keep in mind that although these private opportunities can produce favorable upside, the liquidity of these underlying investments can be unfriendly as it can take a longer period of time for these investments to come to fruition," she said. "Particularly for HF investors, who are offered much friendlier liquidity terms compared to PE funds (1yr lock-ups vs 5-10yr locks). Essentially, lack of liquidity is the price they have to be willing to pay for these higher (private-esque) returns, so liquidity considerations are really important in making these decisions."