Alternative investments, Private markets Including private investments in an asset allocation

By trading off liquidity in a portion of your portfolio and taking on some more complex trading strategies, investors may lower volatility and achieve higher returns.

For example, rather than a traditional 60% stock-40% bond portfolio, we believe a 40% stock-30% bond-30% alternatives portfolio could position investors to capture a wider opportunity set in today’s markets.

As part of our Private Markets Asset Allocation Guide and Hedge Fund Asset Allocation Guide we outline the potential benefits and risks to adding alternatives, while providing a roadmap for building a well-balanced portfolio allocation.

The three main potential benefits of investing in private markets are:

1 - Access to an expanded universe of private companies spanning early-stage ventures, middle-market companies and beyond, in a less efficient market. Fund managers can source opportunities unavailable or inefficiently priced in public markets.

2 - A historical illiquidity premium above public markets, as fund managers take a direct role in management to unlock value and guide growth and/ or impose protections to safeguard capital. Private funds have historically rewarded the lock up of capital through higher returns.

3 - A focus on long-term value creation that prevents panic selling and market timing. Private equity funds invest with multi-year horizons, allowing for building value over time.

Like public markets, investors can tailor private investments to complement income, growth, or blended objectives with different levels of risk. Investors can consider:

• Private equity for capital appreciation
• Private debt for income generation
• Private real estate for inflation-protection and combination of income and appreciation

While all three asset classes are illiquid, they face different types of risks. Private equity faces execution risk, private real estate risks are tied to market risk and occupancy, and private credit is exposed to default risk. A tilt towards private equity suits those with a higher appetite for risk in pursuit of high growth. Lower-risk tolerant investors may lean towards private credit and real estate which historically has offered more stability and income compared to the higher returns in private equity. By allocating across these asset classes, investors can help diversify their portfolios and reduce volatility while increasing potential performance.

When public market valuations reach higher levels, private equity has demonstrated an ability to generate more compelling long-term returns. With US equity valuations at 19.9x trailing earnings, historical data suggests returns over the following decade may average around 7-8% annually. Meanwhile, a diversified pool of private equity investments has historically consistently outperformed public equities, delivering average annual excess returns of 3-4% since 1996 according to Cambridge Associates.

In the current market environment, we are seeing compelling opportunities in the secondary market. Following double-digit declines across both bonds and equities last year, many institutional investors found their private investment allocations exceeded mandated internal thresholds as private investments saw smaller markdowns, forcing them to divest some of their private positions to rebalance back within target ranges. Typically, when investors sell private equity commitments in the secondary market, the transactions clear at around 95% to the Net Asset Value (NAV) of the portfolio companies, or a 5% discount. However, due to the current market environment, secondaries are generally seeing 15%-20% or more in discounts to NAV, creating an additional value potential for investors to increase the internal rate of return.

Investors in private credit are also seeing opportunities to generate higher income than public markets, with stronger covenants protecting capital as economic growth slows. With the recent banking crisis, traditional bank lending to high quality middle market companies has declined, enabling private credit managers to step in to take market share. Private managers are able to negotiate better terms and greater equity buffer (i.e. higher loan-to- value ratios). While typically short-duration and floating-rate in nature, private direct lending is attractive as we see a fall in public bond rates this year and next. Though default rates have ticked higher in both public and private debt instruments, it remains low. So long as deep recession is avoided, we believe the additional return in middle market lending and distressed credit compensates for the risk of a more pronounced economic slowdown.

While real estate investments overall face headwinds, select areas continue to offer compelling returns. Though office and retail properties struggle, residential housing and industrial, such as data centers and logistics, may benefit from demographic changes and technology tailwinds. For long-term investors, private real estate can provide diversification and some inflation protection beyond traditional stocks and bonds, especially in sectors and assets best positioned in a lower economic growth environment.

As you construct an investment plan, your advisor can help you evaluate the right level and mix of private investments and strategies align with your objectives, risk tolerance, and liquidity needs. When adding private investments to a portfolio, here are some key best practices to capture long-term growth while managing downside risks:

• Evaluate how much annual spending you plan to need from your portfolio. Generally, we find that those who distribute 5% or less annually can hold 25-30% in privates, while still meeting capital calls and personal cash flow needs with a low probability of a liquidity challenge
• Conduct due diligence and choose a diversified set of funds across various sponsors as the access and skill of the managers is critical to value creation and risk management
• Diversify across private asset classes, sectors, stages, and geography to manage concentration risks
• Commit across multiple vintage years to mitigate entry point risks and manage cash flows.

By thoughtfully constructing a portfolio to include alternatives, investors can benefit from the added diversification, lower volatility, and enhanced growth potential non-traditional investments offer.

Main contributors: Solita Marcelli, Daniel J. Scansaroli, Jennifer Liu, Christopher Buckley

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

Full report - Regional View US: Going beyond stocks and bonds to include privates in an asset allocation , 15 May 2023.