The evolution of private markets

The below is an extract from our Q4 Asset Allocation Outlook.

Hard and fast private markets data can be hard to come by, but between 2003 and 2019 it’s estimated that private markets AUM has grown by around five times – double the rate of growth seen in public markets.[1]

Unsurprisingly, this rise in AUM has been driven by increasing allocations to private markets from large institutional investors, at the expense of traditional asset classes.[2] As the asset class grows, more access options are becoming available, putting the potential advantages of private markets within reach of a wider range of investors.

Given this backdrop, it seems like an appropriate time to revisit the underlying arguments for private market assets.

Would you say no to a free lunch?

Although we’ve argued that Harry Markowitz’s best-known quote overlooks the psychological cost of rational investment decisions, we are staunch believers in diversification.[3]

But what exactly do we mean by diversification? It may be easier to define what it’s not: a diversified portfolio shouldn’t be significantly overweight single securities, single geographies, or single sectors. And it shouldn’t rely on equities alone for growth.

While diversifying across the familiar traditional asset classes goes a long way towards achieving diversification, we believe the introduction of alternative asset classes can improve risk/ reward outcomes.

Alongside other alternatives, private market assets can help diversify portfolios further. And the typically long-term, illiquid nature of private market investments means they’re well suited to financing large, long-term projects such as renewable energy facilities, affordable housing, and transportation infrastructure. Adding these types of underlying assets can help smooth out returns given their typically stable cash flows.

Illiquidity as a source of returns

In addition to diversification, potential returns are another appeal of private market assets. Unlike public assets that can be bought and sold by virtually anyone, private assets are available to a much shallower pool of investors, often requiring investors to commit capital for longer periods, and to perform in-depth due diligence.

The flipside of this is the illiquidity premium associated with unlisted assets, which should compensate investors for the long-term commitment and additional complexity they take on with these investments. The pursuit of this premium partially explains the increasing allocation to private assets among institutional investors.

Arguably, there are also behavioural reasons for investors interest in private market assets in addition to the potential for an illiquidity premium. The illiquidity of private assets and infrequent pricing can help investors to disregard short-term price fluctuations and focus onto the longer-term return potential. This may obviate the need for steely rationality – a tall order for any human investor – following a decline in asset values.

Full-fat private markets versus listed alternatives

As noted above, the historical difficulty of accessing private markets is slowly easing amid the rapid growth of the asset class. But this raises an important question: can listed alternatives provide the same potential diversification benefits without the illiquidity?

We’ve explored this question in depth before, but in brief, investors should expect similar long-term outcomes when investing in direct and listed property alternatives. Over the short term, listed alternatives respond more quickly to changes in their underlying assets and as a result, unfortunately, trade in line with the changing risk-on/risk-off pattern of other risky assets.

Intuitively, listed and direct exposure have the same underlying economic exposures and so they naturally should provide the same outcomes over the long term. Research supporting this claim is scarce though and so this remains an active topic for sometimes heated debates.

As private markets expand and an increasing variety of investors are drawn to the space, it will be interesting to see if the growing availability of comparable data provides more insights into this question. Watch this space

The above is an extract from our Q4 Asset Allocation Outlook.

 
[1] InvestCorp, BCG, CEM Benchmarking.
[2] CEM Benchmarking data from 2008-2019 shows institutional investors’ allocations to private equity rising from 4% to 6%.
[3] It should be noted that diversification is no guarantee against a loss in a declining market.