Deep Dive: Market turbulence highlights diversification role of private markets

In the current environment of high inflation, high rates and slowing growth, diversifying portfolios with private market strategies such as real assets, private credit and secondaries can help investors navigate market turbulence, experts have told Investment Week.

As companies stay private for longer, more investors are looking to enhance portfolio diversification by allocating to private markets, which can achieve risk-adjusted returns with low correlation to traditional assets and reduced volatility.

Due to their long-term nature, prevailing macroeconomic conditions are less relevant to private markets, compared to investing in public markets.

According to Anna Barath, head of fund investments at Bite Investments, a strategic asset allocation that includes private markets can help steady portfolio returns whatever the weather. 

However, downturns can be a good time to invest in private assets, according to Fidelity International’s CIO for multi-asset, Henk-Jan Rikkerink, as they suffer milder drawdowns and recover quicker than publicly traded assets.

Head to Head: The future of private markets

In the midst of higher debt financing costs and easy money now being withdrawn, private equity, the largest asset class in the sector, is facing a difficult period for both dealmaking and fundraising. 

Reflected in the large discounts of listed private equity, some investors are concerned about how falling equity markets will impact the multiples used within private equity fund valuations, which lag the public market due to the delay in reporting of asset prices.

However, the private markets space offers a wide spectrum of strategies. In a sustained inflationary and rising rate environment, there are certain asset classes that can help hedge, or even benefit, from this while providing downside protection, experts have said.  

Real assets

According to Michael Steingold, director of private markets at Russell Investments, the diversification benefits investors can obtain through real assets are high, as central bank commitments to re-anchoring inflation are less certain following the recent bank sector volatility.

Meanwhile, entry valuations of real assets have also improved for new investors in the past year, he noted, as rising interest rates have caused entry yields and discount rates to increase. 

However, he added that not all real assets are equal today. Infrastructure and alternative real estate, such as healthcare, specialty residential and self-storage, are best positioned, he said. 

ESG more considered in real asset investing than three years ago

“We prefer these assets over traditional real estate, which faces obsolescence threats in office and retail. Other real assets, such as timberland and farmland, also have higher sensitivity to individual commodities rather than broad inflation,” he explained. 

“In contrast, infrastructure and alternative real estate provide investors with the right combination of inflation sensitivity and exposure to secular growth trends.”

Steingold warned that these investments come with high idiosyncratic and concentration risks. Therefore, purposeful investment diversification across sectors and geographies “is required to reliably achieve the benefits of a real assets allocation”, he said.

Private credit 

As traditional lenders continue to pull back from commercial markets, private credit is currently one of the fastest growing areas of private markets, with $1.4trn of assets under management globally at the end of 2022, up from about $500m in 2015, according to Preqin.

Unlike bonds, private loans are not traded but instead negotiated privately and tailored to the borrower’s needs, with maturity between three to seven years, and a typically variable, or floating, interest rate. 

The private market’s dependency on the public markets

The floating rate nature of the securities can help guard against further rate rises, as well as add an “attractive” cash yield component that increases when interest rates rise further, said Barath.

Kirsten Bode, co-head of private debt for the Pan-European region at Muzinich, noted that a more cautious lending backdrop for banks on the back of recessionary fears, alongside the long-term underlying trend of broader bank retrenchment, will increase lending opportunities for private lenders.

“Private debt will continue to grow despite macro challenges supported by increased opportunities as private lenders occupy the space left by banks; the asset class may offer higher returns with lower volatility than those available in public markets,” she said.

Secondaries and manager selection 

Due to the recent declines in public markets, which have not yet been matched by lagged private asset valuations, many institutional investors have been forced to sell private assets to rebalance portfolios in a phenomenon known as the denominator effect. 

Secondary funds, or secondaries, purchase existing interests or assets from primary private fund investors, offering a reduced blind pool and J-curve risk, as portfolio assets are known and funded.

The denominator effect has caused supply in private asset secondary markets to be high, and prices are lower than they have been for several years. As a result, secondaries can give investors access to good managers at relatively low prices at the moment, Fidelity’s Rikkerink said.

Deep Dive: Private markets take steps towards the ‘mainstreaming’ of ESG

Regardless of strategy, private market investments exhibit a much higher degree of performance dispersion among managers than traditional asset classes. This can be even higher during a downturn. 

According to Rikkerink, this means that selecting the best managers, often those who have experienced different cycles and understand how to manage portfolio companies through times of high inflation and interest rates, is “critical” to achieve desired investment outcomes.

Considering the complexity of private markets, Barath added that before committing, investors should evaluate their individual circumstances and look out for the ‘five Ps’ when selecting managers: Portfolio fit, (Investment) Philosophy, People, Performance and (Legal) Provisions.

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