Investors First: Benchmarking the Modern Market

Key Concepts

Private Markets vs. Public Markets: The distinction between companies that are publicly traded on stock exchanges and those that remain privately held.
Morningstar Pitchbook US Modern Market Index: A new index designed to track both public and private companies, reflecting the evolving investment landscape.
Companies Staying Private Longer: A trend where companies are delaying or foregoing IPOs, raising substantial capital privately.
Retail vs. Institutional Investors: The different needs and approaches of individual investors versus large financial institutions.
Transparency in Private Markets: The challenge of obtaining consistent and reliable data for private companies compared to public ones.
Secondary Markets: Platforms where existing shares of private companies can be traded, providing liquidity and interim valuations.
Survivorship Bias: The tendency for indexes to overrepresent successful companies, potentially skewing performance data.
AI (Artificial Intelligence): A dominant theme in both public and private markets, driving innovation and investment.
Investable Products: The development of financial instruments (like ETFs) that allow investors to gain exposure to blended public and private market indexes.

The Evolving Investment Landscape: Blending Public and Private Markets

This discussion explores the significant shift in investment markets, driven by companies staying private longer and the increasing importance of private markets. The conversation centers around the launch of the Morningstar Pitchbook US Modern Market Index, a new benchmark designed to capture this evolving reality.

The Rationale Behind the Modern Market Index

Sandy Bhari from Morningstar explains that traditional public market indexes are no longer sufficient. For decades, these indexes accurately reflected the economy and investor opportunities because companies listed earlier in their lifecycle. However, the market has changed:

Companies are staying private longer: The average age to IPO has doubled to approximately 12 years, as companies can raise significant capital without going public.
Large, innovative companies are private: Examples like OpenAI, which raised $40 billion in a private round (twice the size of the largest IPO historically), and Nvidia's substantial private investment highlight this trend.
Material shift in market composition: Privately held venture capital-backed companies now represent 8-10% of the total equity market, up from 1% in 2000, making it a significant portion of the economy.

This evolution presents three key challenges for investors:

Incomplete Benchmarks: Public market indexes fail to represent the full investor opportunity set.
Underrepresentation of Innovation: Companies transforming the economy, particularly in sectors like AI, fintech, and biotech, are often missing from public benchmarks.
Lack of Transparency: The absence of consistent data for private companies makes measurement and comparison difficult.

The Morningstar Pitchbook US Modern Market Index aims to address these challenges by providing a more comprehensive view of the market.

Investor Evolution and Response

Paul Condra from Pitchbook discusses how investors are adapting:

Institutional Investors: Have been engaging in hybrid investing (including private markets) for years.
Retail and Wealth Management: The new frontier is making private market exposure accessible and understandable to retail investors. Indexes like the Modern Market 100 are crucial for financial advisors to explain potential portfolio allocations and performance relative to public equities.
Demand for Private Market Exposure: The trend of companies staying private longer and innovation occurring in late-stage startups creates genuine demand from retail investors to access these opportunities through traditional wealth channels.

Risks and Transparency in Private Markets

Eric Compton, an equity research leader, addresses concerns about the emerging trend:

Risk of Retail Investors Entering Late: There's a potential risk that retail and wealth channels are entering the private markets at a later stage in the cycle, when institutional investors may be reducing their exposure.
Current Market Cycle: A lack of exits in private markets, coupled with increased capital flowing from retail wealth channels, could lead to investors chasing scarce opportunities. Fund performance is down, but fundraising from retail is up.
Cyclical Impacts: Investors need to understand that private markets are not immune to cyclical impacts, and retail investors, who typically seek more liquidity, may not always experience the same long-term return profiles as institutional investors.
Transparency Challenges: The primary issue is the lack of daily pricing and performance data for private assets. Unlike public companies, where pricing is readily available, private company valuations are often set during infrequent funding rounds.
Morningstar's Role: Morningstar aims to provide a neutral, objective source of information through indexes like the Modern Market 100, using a methodology to offer a view of pricing in this market segment. Trust in the provider and their process is paramount.
Trade-off between Transparency and Illiquidity Premium: Increasing transparency in private assets might diminish the illiquidity premiums that have historically existed.

Frameworks for Research and Comparison

Eric Compton also touches upon how this evolution impacts equity research frameworks:

Public vs. Private Trade-offs: The continuum of transparency, real-time price discovery, and liquidity influences company choices.
Fundamental Analysis Remains Key: Regardless of public or private status, investing in good companies based on sound fundamentals is crucial.
Benchmark Evolution: As the universe of opportunities expands, benchmarks need to adapt.
Changing Return Structures: Investments in companies within the Modern Market 100 index, particularly AI-related names, exhibit heavy right-tail skewed, power-law return structures. Investors must understand these inherent upsides and risks.
Correlation: The correlation between public and private markets may be higher than perceived, especially with public markets being led by a few AI companies, mirroring trends in the private benchmark.
Diversification: While diversification can be lessened on a sector (technology) or thematic (AI) basis, it may increase on a company maturity basis, offering access to earlier-stage companies.

Accounting for Valuation Differences and Index Performance

Sandy Bhari addresses the challenge of valuing private assets:

Pricing Complexity: Reconciling fundamentally different pricing ecosystems (real-time public trading vs. funding rounds every 12-18 months for private companies) is a significant challenge.
Role of Secondary Markets: Secondary markets provide a mechanism for early investors and employees to realize value before an IPO. These active markets generate daily transactions, setting intermediary prices between funding rounds.
Morningstar's Methodology: A robust model integrates multiple secondary market data sources to separate signal from noise, calculating a single, consolidated daily market price for private companies that is reliable and representative of real trading values.
Index Performance: The index has performed well and outperformed its benchmark (public companies within the index). This outperformance is attributed to the private companies driving returns.

Paul Condra adds that the hybrid index exhibits smoother performance, less susceptible to the daily volatility seen in public markets due to the less frequent pricing of private assets. He emphasizes the need for continuous iteration in explaining the pricing methodology and building user trust.

Pitchbook's Data Uniqueness

Paul Condra explains Pitchbook's unique contribution:

Comprehensive Data Capture: Pitchbook collects extensive data points on private companies, often released through press releases, and consolidates this information.
Methodology Enhancement: This data is integrated into methodologies and algorithms to enhance valuation production.
Secondary Market Partnerships: Partnerships with secondary brokerages provide crucial pricing information.
Ongoing Development: Pitchbook is continuously working to advance its private company valuation capabilities.

Addressing Survivorship Bias

Sandy Bhari clarifies the index's selection criteria:

Representing Leaders: The index is designed to represent the largest and most influential public and private companies driving the economy and innovation.
Selection by Size: It includes 90 of the largest US-based publicly traded companies and 10 of the largest privately held, late-stage venture capital-backed companies, selected based on size.
Investor Access: This inclusion provides investors with exposure to companies they might not otherwise access through traditional public market indexes.
Inherent Characteristic of Indexes: Survivorship bias is a characteristic of most indexes, where larger market cap companies tend to dominate.

Key Companies and Themes

Eric Compton highlights the prevalence of AI:

AI Dominance: A significant theme across both public (Nvidia, hyperscalers, Broadcom) and private companies (OpenAI, Anthropic, XAI, Databricks) in the index.
OpenAI's Significance: OpenAI is considered potentially the most important company globally due to its impact on the future of AI and technological development.
Research Workflow: While the index doesn't change his personal research workflow, it's highly relevant for Portfolio Managers (PMs) and financial advisors discussing asset allocation and benchmarks.

Precedent for Other Asset Classes and Global Markets

The panel discusses the potential for this blended benchmark approach to set a precedent:

Global Trend: Sandy Bhari believes the Modern Market 100 is a first step in redefining the equity landscape globally. The logic applies to regions like Europe and Asia, which have strong private market ecosystems. The goal is to create a global family of modern market indexes.
Investable Products: Paul Condra suggests the next crucial development is the creation of more investable products around these blended indexes. Since constituents of a blended index cannot be directly owned, synthetic structures using derivatives and options are needed. This aligns with ETF innovation, potentially leading to dynamic ETFs that adapt to market outcomes.
Future of Investing: The blending of public and private assets, along with ETF innovation, represents the future of investing, providing more investors with desired exposure and enabling them to achieve specific investment outcomes.
Catalyst for Retail Demand: Eric Compton sees this as a catalyst for more conversations between advisors and clients on the retail side, potentially increasing demand for private assets if returns are strong. For institutional investors, it's an acknowledgment of existing trends and market evolution.

Conclusion

The discussion underscores a fundamental shift in how markets are structured and how investors should approach them. The Morningstar Pitchbook US Modern Market Index represents a significant step towards reflecting this new reality by integrating both public and private companies. While challenges related to transparency and valuation persist, the development of robust methodologies and the potential for new investable products signal a future where investors have more comprehensive tools to navigate the evolving global investment landscape. The dominance of AI as a theme across both public and private markets highlights the interconnectedness of innovation and capital formation.