investment insights
The role of private assets in a changing investment landscape
Key takeaways:
- Our long-term scenarios point towards higher inflation volatility and potentially higher average inflation in the years to come, leading to higher neutral levels of interest rates than pre-pandemic
- In a fracturing geopolitical landscape, alternative investments can play an increasingly important portfolio diversification role
- Private assets can extend the opportunity set and provide additional sources of portfolio returns and diversification for investors with an appropriate time horizon and risk tolerance for illiquid assets
- Selecting the right managers is key, as is adequate diversification across all sub-asset classes, to benefit from their different characteristics throughout the economic cycle.
Geopolitical fractures and a changing investment paradigm
We face a changing investment landscape. Many governments around the world are no longer focussing on the benefits of global cooperation. Increasingly, countries trade and invest with their “friends” while avoiding their competitors, presenting risk not only to supply chains and the real economy, but also to global financial assets.
While we expect disinflationary trends to continue this year, the fragmentation of global trade and supply chains, together with an increased appetite for fiscal largesse, may contribute to structurally higher average inflation and inflation volatility in the years ahead. This means likely higher neutral interest rates. These elements underpinned our December 2023 review of 10-year capital market assumptions.
These updated assumptions have implications for investment returns. They resulted in several changes to our strategic asset allocation, including a move towards a simpler overall portfolio architecture, a focus on core holdings, more fixed income in certain profiles and a tilt towards quality. Fixed income assets are back as a driver of portfolio returns, as opposed to the source of mostly risk they have been for the last few years.
Faced with more risks in global investment opportunities, our new strategic asset allocation reflects a more pronounced home bias in equity allocations. The stock-bond correlation may also be slower than usual to normalise, highlighting the need for complementary portfolio exposures that add sources of diversification.
The shift from greater globalisation towards greater strategic competition is just one of many shifts that are unfolding. The need to accelerate the energy transition presents its own set of risks and opportunities, many of which we expect will manifest in private markets. Transformative technologies are also coming to the fore, with developments around generative artificial intelligence (AI) driving new investment flows.
In a fracturing world, a potentially harsher stance on immigration could exacerbate constraints in labour supply and add to the appeal of AI technologies as a means to increase productivity and reign in labour costs. We would expect increasing public and private investment in AI and digitalisation, both equity and infrastructure, to follow.
We see all these factors translating into a more important role for alternative assets in portfolios. For investors who can place capital for the long run and tolerate illiquidity, diversified exposure to a range of private assets can increase the investment opportunity set and improve a portfolio’s overall returns. Below we summarise our key views on the asset class, with a focus on private equity, its risks, and how it can help to optimise portfolio outcomes.
A ‘total wealth’ approach
Private assets are an integral part of our strategic asset allocation for investors with an appropriate time horizon and risk tolerance. They can play an important role in diversifying portfolios from publicly-listed assets, across the full economic cycle. While private equity accounts for two-thirds of all private assets, the varying drivers and resulting dynamics of private debt, infrastructure, and real estate offer further opportunities.
Professional investors, from university endowments to pension funds, have increasingly shifted their asset allocation toward private assets. Family offices expect 52% of their portfolios to be invested in alternative assets in 2024, according to a survey by KKR, with a focus on investments in private credit, infrastructure and private equity. The accessibility of private assets for private investors has also improved.
Incorporating private assets can help improve the quality and robustness of portfolios. Our modelling shows that the inclusion of private equity would have improved the performance profile of diversified portfolios over time compared to those without private equity. However, that comes at the cost of lower liquidity of the overall portfolio.
Earlier growth capture through private equity
Private equity can extend the set of investment opportunities for eligible investors. Compared to twenty years ago, companies are now staying private for longer. It took only three and six years for Amazon and Google to be listed respectively, while Uber listed after 10 years and at a much higher market capitalisation. Much of the value of newly formed ‘unicorns’, or start-ups valued at over USD 1 billion, especially at the early stages of their innovations, can only be captured before they are listed. The inverse observation is that the opportunity set in listed markets has narrowed since the 1970s. The total number of listed companies in the US fell from 8,000 to 4,600 from 1996 to 2022.
As fewer IPOs and more delistings have shrunk the number of listed firms, public markets have experienced a concentration in wealth creation. Leading companies, primarily in the tech sector, have leveraged their competitive advantages to capture a disproportionate share of value creation and market capitalisation.
Private equity has outperformed public equities
For a balanced picture, private equity performance should be assessed through multiple lenses, including internal rates of return1 (IRR), investment multiples, and a comparison with public markets. According to Cambridge Associates data, private equity funds have delivered an average IRR of around 16% since 1985. Of course, IRRs only tell part of the story. The more difficulties managers have in deploying the capital they have raised (or ‘dry powder’, which is currently elevated), the lower the total IRR, even if returns on invested capital are very good.
To solve this, private equity, when compared to public markets, is often evaluated using the public market equivalent (PME) benchmarking methodology. This aims to provide a consistent framework for comparison, matching the timing and magnitude of private equity cash flows with equivalent public market investments, enabling investors to judge the relative performance of their private equity investments. On average, since 1985, value added by private equity is 3.8% estimates Cambridge Associates.
The performance gap between private and public markets fluctuates over time. 2020 saw strong private equity outperformance as some healthcare tech companies were big beneficiaries of the Covid crisis. Conversely, with valuations marked down and little distributed capital in 2023, some areas of private equity underperformed public markets. Here we see some tentative signs of recovery. Deal value globally rose 58% in the fourth quarter of 2023 on the prior three months, according to data provider Preqin, while private equity managers report more encouraging deal flow and a relatively strong pipeline of opportunities.
With the cost of debt having risen significantly, investors often question the potential for value creation in private equity. However, we have witnessed a shift from financial engineering to operational improvement in private equity following the global financial crisis, which represents a significant evolution in the industry’s approach towards generating returns.
Private equity should retain an edge over public markets
The pandemic years, from 2020 through 2022, saw private assets attract a total of USD 4 trillion across all sub-asset classes, according to management consultancy Bain & Company. The last two years, 2021 and 2022, were respectively the highest and second-highest totals ever raised. By contrast, in the first three months of 2023, the mergers and acquisitions market recorded its slowest first quarter of any year in a decade, according to data from Refinitiv. The combination of higher borrowing costs, uncertainty about slowing economies, and the disruptions in regional US banks all played a part.
This slowdown in deal activity curbed valuations, particularly for venture and growth capital funds, creating opportunities for those with capital to deploy, and those with a focus on distressed assets. Private equity funds that launched in difficult markets have historically performed well, according to data from Cambridge Associates. Relative valuation of private equity deals versus public equities has returned to long term averages and is one of the reasons why we believe private equity can sustain its edge. This is reflected in our own forward-looking 10-year return expectations.
Manager selection is critical
This economic cycle is opening up new avenues for value creation. We expect the higher-for-longer interest rate environment to favour the strongest fund managers: those who actively work to transform their assets. We favour private equity managers with strong industry or sectoral expertise, scalable operational capabilities, and access to a deep bench of advisors and experts. Instead of relying on access to leverage or potential multiple expansion, successful investments now require strategic and operational improvements, as well as tangible profit growth. This reinforces the importance of careful fund manager selection. Performance dispersion in private equity is markedly wider than in other asset classes. The difference between first quartile and bottom quartile funds was 17 percentage points for 1986-2021, according to Preqin data.
Academic research has also provided evidence of performance persistence among private equity fund managers, especially in venture capital and among top-performing funds. Data show a tendency of teams which have performed well in the past to continue to do well in subsequent funds.
Private asset investments do of course come with risks: loss of liquidity (capital can be ‘locked up’ for up to 10 years), and a risk of potential capital loss. Diligent manager selection, and access to the best-performing funds is important.
Overall, we believe that a disciplined, selective, and gradual approach to investing in private assets is paramount, as is adequate diversification across all sub-asset classes, to benefit from their different characteristics throughout the economic cycle.
1 The IRR is the constant rate of return that would produce the total ending value of a portfolio given the magnitude and timing of the cash flows (Source: CFA Institute).
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