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Duncan Lamont | Adding return and lowering risk with private assets

Duncan Lamont | Adding return and lowering risk with private assets
09-10-24 / Duncan Lamont

Duncan Lamont | Adding return and lowering risk with private assets

Johannesburg - Private assets bring a number of advantages to portfolios, from return enhancement, to income, to reduced risk, to diversification via differentiated drivers of returns. But increased demand means investors should seek out less crowded markets. Access to deals and focus on inefficient markets are critical to identifying attractive investment opportunities.

The Growth Trajectory of Private Assets

Private assets have seen a dramatic rise in assets under management (AUM), growing from $700 billion in 2001 to an astounding $13.6 trillion by mid-2023. Although this is still small relative to the $86 trillion market size of the combined public equity, corporate, and high yield bond markets, private market growth has been much faster. Their near-20-times increase in size dwarfs the three-times rise in the size of the global public equity and corporate bond markets over the same period. As this only covers funds, rather than separate mandates or individual investments, the true size of the private market universe is even larger. Private markets' growing scale means investors cannot afford to ignore them when making asset allocation decisions.

Institutional investors have been responsible for the lion's share of the demand, with average allocations to private assets rising from 17% a decade ago to 27% at the start of 2023.

The attraction of private assets

There are several benefits that make private markets attractive.  Firstly, the capacity to generate higher returns. Both private equity and private infrastructure, for example, have both delivered higher returns historically when compared to public equity and infrastructure markets. One of the reasons for this is the proximity of private equity managers to their investee businesses which allows them to directly influence operations and strategic decisions for better outcomes.

Another aspect that supports higher returns is around price. Private assets are generally more complex and illiquid which tends to make them cheaper investments.  

Income generation is another key advantage, especially when it comes to private assets such as private debt, infrastructure investments and real estate. These asset classes can provide stable cash flows, which provides an attractive option or investors looking for income options.

Additionally, private assets can reduce portfolio risk through diversification. Exposure via public markets is decreasing at a rapid rate as the delisting trend continues around the globe. Public markets are therefore providing exposure to an increasingly narrow subset of older, more mature companies. Investors focused solely on public markets risk missing out. Furthermore, if high quality companies are turning their backs on the public market, the risk is that the quality of the market deteriorates over time.

Overcoming the hurdles

Increasing demand for private market assets, while encouraging, has led to more competition in the space.  Increased interest in private assets has led to large amounts of capital being raised in the past decade. "Dry powder," money raised but not yet invested, has hit record highs. High fundraising runs the risk of too much money chasing the same deals, higher prices being paid, and lower future returns.

Better opportunities for investors can be found in less crowded markets and by leveraging the credibility and reputation of experienced investment managers to gain access to deals that others may miss. Deal access has become one of the most important edges that a successful investor can lay claim to. Smaller or more complex transactions, such as family-run business buyouts, often present better opportunities compared to highly competitive large-scale deals.

In private debt, structuring is an essential skill, which presents a barrier to entry. This is especially true when dealing in less crowded areas where structure means more than just covenants. It may mean "matched term financing" or "Special Purpose Vehicles" or "tax blockers". Anyone can buy a corporate bond, but not everyone can draft, understand, and negotiate complex legal agreements.

The Importance of Manager Selection

One consequence of the greater scope for private asset managers to steer their investments is a wider dispersion of returns than is typical in public markets. The difference in return between top and bottom quartile buyout funds globally has been around 15%, on average. Manager selection is more important when investing in private assets.

Private assets represent a powerful tool for investors

Private markets offer a rich variety of investment options which can diversify and enhance risk and return for investors. With their growing clout, more and more financing is taking place privately. Investors focused solely on public markets risk missing out. There is no shortage of attractive opportunities, but, with increased interest has come increased competition. Investors should seek out less crowded markets to benefit from the return and risk enhancement that private assets can offer.

*Duncan Lamont is Head of Strategic Research, Schroders.

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