CIO Key Investment Ideas: Diversify into private equity

At a glance

Private markets can play a crucial role in portfolios. With returns on traditional investments likely to be lower in the future than over the past decade, adding alternative assets such as private equity may be a good way to enhance returns and portfolio diversification. Now may also be a good time to increase exposure, as private equity has experienced above-average returns following periods of market dislocation. At present, we see strong potential in managers focused on distressed investing, in which managers buy debt or equity of stressed companies at a discount. Private markets can also enable investors to access industries that are being boosted by the pandemic, including health technology, biotechnology, online education, and food delivery.

Opportunities for investors in private markets

The advantages of having private market exposure in a portfolio are increasing. With returns on traditional assets likely to be lower in the future than over the past decade, private markets can be a good way to enhance returns. The asset class typically generates higher returns than listed markets given its ability to earn an illiquidity premium of around 1–3 percentage points a year, plus the additional alpha potential.

Due to their non-listed nature, private equity investments are also good differentiators in a portfolio. They can invest in smaller or earlier-stage companies, take a more active ownership approach, and exhibit lower reported volatility versus public equity investments.

We also believe that now is a good time to add to private markets. The best vintages for private equity firms have often coincided with dislocations in public equity markets, such as in the years 2001 and 2008. We believe the current COVID-19 crisis may also offer an attractive entry point for long-term investors seeking greater exposure to private markets.

At present we see particular opportunities in several categories of private market funds:

Industries boosted by the pandemic: Private market funds can provide exposure to businesses that have been given a lift by the COVID-19 crisis, including health technology, biotechnology, online learning, and food delivery. Pure exposure to such businesses can be hard to achieve in public markets.
Distressed investing: Distressed investing typically refers to strategies that purchase debt or equity of stressed companies at a discount with the aim of selling them later with a profit. The economic fallout from the COVID-19 pandemic has been severe, leaving many businesses facing revenue losses or risk of closure. Given this and the record issuance of speculative grade debt over the last 10 years, we expect a sizable supply of stressed, distressed, and default situations across both public and private markets in the coming quarters.
Value creation: The opportunity set is also large at present for manager with dedicated operational value creation capabilities focused on corporate integration, divestitures, cost reductions, and restarting growth initiative, which all play an important role in ensuring companies withstand the strains imposed by the pandemic and prepare for future recovery and growth post crisis.

So, we believe investors with the ability to tolerate some illiquidity in part of their portfolio should consider an exposure to private markets. In addition, with more funds available for investors of varying levels of wealth, it is increasingly possible to have access to the asset class.

Key investment takeaways:

Adding private markets to a portfolio can have a variety of benefits, including enhanced returns and diversification.

Now is a good time to increase exposure since returns on private market vintages have typically been higher in years of dislocation.

We see particular opportunity in funds that focus on industries boosted by the COVID pandemic, including health technology, biotechnology, online learning, and food delivery.

Distressed investing strategies—purchasing debt and equity at a discount with the aim of selling at a profit—also enjoy a wide range of opportunities to generate attractive returns at present.

Non Traditional Assets

Non-traditional asset classes are alternative investments that include hedge funds, private equity, real estate, and managed futures (collectively, alternative investments). Interests of alternative investment funds are sold only to qualified investors, and only by means of offering documents that include information about the risks, performance and expenses of alternative investment funds, and which clients are urged to read carefully before subscribing and retain. An investment in an alternative investment fund is speculative and involves significant risks. Specifically, these investments

1. are not mutual funds and are not subject to the same regulatory requirements as mutual funds;
2. may have performance that is volatile, and investors may lose all or a substantial amount of their investment;
3. may engage in leverage and other speculative investment practices that may increase the risk of investment loss;
4. are long-term, illiquid investments, there is generally no secondary market for the interests of a fund, and none is expected to develop;
5. interests of alternative investment funds typically will be illiquid and subject to restrictions on transfer;
6. may not be required to provide periodic pricing or valuation information to investors;
7. generally involve complex tax strategies and there may be delays in distributing tax information to investors;
8. are subject to high fees, including management fees and other fees and expenses, all of which will reduce profits.

Interests in alternative investment funds are not deposits or obligations of, or guaranteed or endorsed by, any bank or other insured depository institution, and are not federally insured by the Federal Deposit Insurance Corporation, the Federal Reserve Board, or any other governmental agency. Prospective investors should understand these risks and have the financial ability and willingness to accept them for an extended period of time before making an investment in an alternative investment fund and should consider an alternative investment fund as a supplement to an overall investment program.

In addition to the risks that apply to alternative investments generally, the following are additional risks related to an investment in these strategies:

• Hedge Fund Risk: There are risks specifically associated with investing in hedge funds, which may include risks associated with investing in short sales, options, small-cap stocks, "junk bonds," derivatives, distressed securities, non-U.S. securities and illiquid investments.
• Managed Futures: There are risks specifically associated with investing in managed futures programs. For example, not all managers focus on all strategies at all times, and managed futures strategies may have material directional elements.
• Real Estate: There are risks specifically associated with investing in real estate products and real estate investment trusts. They involve risks associated with debt, adverse changes in general economic or local market conditions, changes in governmental, tax, real estate and zoning laws or regulations, risks associated with capital calls and, for some real estate products, the risks associated with the ability to qualify for favorable treatment under the federal tax laws.
• Private Equity: There are risks specifically associated with investing in private equity. Capital calls can be made on short no-tice, and the failure to meet capital calls can result in significant adverse consequences including, but not limited to, a total loss of investment.
• Foreign Exchange/Currency Risk: Investors in securities of issuers located outside of the United States should be aware that even for securities denominated in U.S. dollars, changes in the exchange rate between the U.S. dollar and the issuer’s "home" currency can have unexpected effects on the market value and liquidity of those securities. Those securities may also be affected by other risks (such as political, economic or regulatory changes) that may not be readily known to a U.S. investor.