2022 has without a doubt been a challenging year across asset classes. But private markets overall experienced less drawdowns than in public markets. (UBS)

Yet, many ultra-high net worth investors remain underallocated in this space. To be sure, investing in private assets requires a greater tolerance for both illiquidity and lower transparency and also an understanding that performance has to be evaluated over a long period. But it is this patience of capital that allows managers to execute multiyear value creation plans and capitalize on long-term market trends, providing them with an edge over public markets. We currently recommend allocating 10% to 30% to private investments to diversify and boost returns if they fit with your objectives and risk tolerance.

Private markets experience lower markdowns

2022 has without a doubt been a challenging year across asset classes. But private markets overall experienced less drawdowns than in public markets. Private equity (PE) managers have been slow to mark down their portfolios, with 1Q22 US PE down almost 0.35% and 2Q22 down 5%, according to Cambridge Associates benchmarks. In comparison, the S&P 500 was down 4.6% and 16.1%, respectively, during these periods. Additionally, middle market direct lending strategies have insulated fixed income losses in a rising rate environment; as of 2Q22, private credit had a year-to-date return of 2.3%, while 10-year bonds and leverage loans were down 4.6% and 10.6%, respectively.

While we expect to see additional markdowns in private equity through the year-end due to further market deterioration, we do not believe they will mark down to the full extent as that of public equities. This has certainly been the case in the last three recessions, where PE markdowns on average reflected only 55% of the S&P 500 drawdown.

The most obvious reason for the lower markdown is that PE managers are less impacted by market news flow and investor overreactions; sponsors are not forced-sellers in a market downturn, which provides price stability. But there are other fundamental reasons as well. Private investment managers have greater control over their portfolio companies and are able to cut costs, delay capex spending, and use other levers such as securing additional financing or injecting additional equity during difficult times to preserve profitability.

Additionally, there is a value play in privates. Looking at historical data from Preqin for the last 10 years, the median US PE entry enterprise value (EV) to earnings (EBITDA) ratio is lower than the average Russell 2000 EV to next-12- months EBITDA by up to 46%, providing a cushion against drawdowns.

How to invest in private equity

For existing private equity investors, we expect soft performance in internal rate of return through year-end 2022. We continue to believe that investors should maintain the course of vintage diversification, continue to invest in good managers, and look for opportunities in market dislocations For investors yet to build exposure to private markets, this may be a good entry point. Investing in vintages after public market peaks have historically generated outsize returns.

We continue to see attractive returns for value-oriented buyout strategies with a focus on healthcare and technology from a thematic perspective. The growing trend toward a green economy, particularly with many countries' continued financial and policy commitments to climate and sustainable initiatives at the 27th UN Climate Change Conference (also known as COP27), is also providing new investing strategies in a growing sector.

And finally, secondary markets could also be a timely opportunity for both new investors and existing investors looking to enter the market at a discount. As public markets have repriced, many institutions have private equity allocations that are in excess of their long-term target range and are looking to unwind some deals in the secondary market to get back within their mandated allocation ranges. This historically has created opportunities for investors to buy in the secondary market at significant discounts.

With higher rates and a potential recession, be more selective in private credit

Private credit fundraising activity ballooned over the past decade amid a global hunt for yield in a near-zero interest rate environment. As real yields rise back to long-term averages, many investors who hunted for yield are able to find more liquid investments that may align with their income objectives, and the attractiveness of the illiquid investment premiums may decline relative to public markets.

We still believe in middle-market direct-lending private credit managers who can manage rising interest rates, have strong discipline in underwriting investments, have a senior cap table focus, have a quality and diverse portfolio, and have an experienced team to maximize recoveries. However, given a potentially extended high interest rate environment, market recession, and likely pickup in defaults, the risks to direct lending strategies have increased. Many investors have piled into the direct lending space as part of a global hunt for yield. And as we look at these potential risks, we recommend investors review their allocation with their advisor and right size their total position in a portfolio in line with their risk appetite and objectives.

If higher rates persist and we experience a more prolonged recession, defaults could rise, cumulative losses could accrue, and private debt investors might face a less liquid exit environment. If we do enter a period of high defaults, we recommend allocating to distressed debt funds for investors seeking fixed income combined with a potential for higher returns. Historically, distressed debt managers have earned higher returns during periods of higher corporate default rates.

Main contributors: Solita Marcelli, GWM Chief Investment Officer Americas and Daniel J. Scansaroli, Head of Portfolio Strategy & UBS Wealth Way Solutions

Content is a product of the Chief Investment Office (CIO).

Original report - The value of private markets in your portfolio, 7 December, 2022.

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