The appropriate weight of private assets in portfolios is arguably the key question for strategic asset allocation today.
These investments were the fastest-growing share of many portfolios for the past decade: Will the abrupt change in investment regime and greater need for liquidity halt that increase?
We argue that all the forces that have ushered in higher private allocations in recent decades are still in place, if anything they've strengthened. Allocations must still grow as investors seek higher inflation-protected returns and diversification. There are, however, new challenges in the form of greater liquidity needs and near-term overweight positions for some investors.
We also discuss the allocation within private markets and suggest that the marginal flow of capital, from a strategic perspective, should be directed to areas other than private equity, such as private debt, natural resources and infrastructure investments.
Should asset owners increase their exposure to private assets? This is arguably the most important strategic allocation question for 2023. Exposure has risen for many types of investors in recent years, and has been one of the primary dynamics of change in asset allocation. The rationale was rooted in dismally low return expectations and a need for diversification. That case held in an era when liquidity was plentiful and expectations for bond returns were firmly negative in real terms.
Does the case still hold in the current environment? To put it more bluntly, after the painful declines in public bond and equity markets since early 2022, do investors still need private assets in the same way? We'll make the case that private asset allocations still need to rise in general—but the case has become more finely balanced.
We see the role of private assets in asset allocation as a secular shift that has further to go—we stress that this is a strategic allocation statement distinct from a tactical view. Private assets play both return and diversification roles, and the case for a greater supply of private capital is driven by the shrinking amount of public equity capital and a retrenchment among traditional lenders. The declining share of credit provided by traditional lenders (banks) has been a multi-year process, but it's still very much a current issue. In the wake of the Silicon Valley Bank demise and recent banking turmoil, more regulation is likely, which will likely further limit credit creation by banks. The longer-term opportunity in private assets is here to stay, notwithstanding the considerations of specific investors, such as liquidity and the potential for near-term writedowns heading into a period of slower growth.
When considering private allocations, a key question is: What is one paid to hold an illiquid private asset? The traditional answer is an illiquidity premium, spurring debate on whether that's still true across sub-categories of private assets today. However, there are other potential return sources, such as the role of legal structure (including legal documentation and financial covenants) and control (a sole investor or group of like-minded investors) in contributing to an idiosyncratic return stream and the ability to access segments of the economy not well represented in public markets.
Why has the allocation to private markets surged in the last decade? On the demand side, it was a response to low return expectations across asset classes and a need for diversifiers under the auspices of plentiful liquidity from central banks. There was a supply side force, too, with a decline in the stock of public equity (higher prices but fewer shares) and banks' retreat from providing credit, reinforced by borrowers' growing appreciation of the speed and flexibility of private-market execution. The supply argument is augmented by the recognition that, in many cases, there's more flexibility in loan structuring with private capital. Most of these forces remain in place today.
About the Authors
Inigo Fraser Jenkins is Co-Head of Institutional Solutions at AB. He was previously head of Global Quantitative Strategy at Bernstein Research. Prior to joining Bernstein in 2015, Fraser Jenkins headed Nomura's Global Quantitative Strategy and European Equity Strategy teams after holding the position of European quantitative strategist at Lehman Brothers. He began his career at the Bank of England. Fraser Jenkins holds a BSc in physics from Imperial College London, an MSc in history and philosophy of science from the London School of Economics and Political Science, and an MSc in finance from Imperial College London. Location: London
Matthew Bass is Head of Private Alternatives and a member of the Operating Committee. As head of AB's Private Alternatives SBU, he is responsible for the leadership and strategic growth of the business, which includes all of AB's private market investment strategies. Previously, Bass held various roles in the firm's Alternatives business (including as head of Alternatives and Multi-Asset Business Development, and COO), where he was responsible for business strategy, sourcing of new investment teams, product development and capital raising. Prior to joining the firm in 2010, Bass was a program director at the US Department of the Treasury, responsible for the design and implementation of various real estate and real estate capital-markets programs pursuant to the Troubled Asset Relief Program. Before that, he was a vice president at The Blackstone Group's GSO Capital Partners unit, where he was involved in analyzing, evaluating and executing private debt and equity investments. Bass began his career in the Financial Institutions Investment Banking Group at UBS, where he was responsible for executing M&A and capital-raising transactions for banks, asset managers and specialty finance companies. He holds a BS in finance from Lehigh University. Location: Nashville
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