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Market weekly – Diversified private markets: A source of illiquidity premiums (Read or listen)

Negative cash flows, pressure to diversify risk exposures, stricter investment regulations – institutional investors are facing many issues. These are also making holding listed equities harder, while low bond yields add to the challenges of sourcing adequate returns. Where can attractive alternatives be found?

Listen to the podcast with Julien Halfon on investment solutions for institutional investors at a time when low and rising interest rates and market volatility present challenges.  

One way to improve the risk/return profile of institutional portfolios is to capture the credit and/or equity illiquidity premiums by investing in diversified private debt and private equity portfolios.

Additionally, investing in private markets enables institutional investors to meet their demand for sustainable assets by directly accessing greenfield and brownfield, senior and junior, and developed and emerging market green assets. Increasingly, institutional investors are seeking not just such ESG oriented assets, but they also want to climate-align their portfolios to the Paris Agreement.

The challenge

Many institutional investors are shunning the volatility associated with listed equities and investing in other asset classes. For example, defined benefit pension funds have been slowly, but steadily moving out of traditional listed equities and into fixed income, index-linked and corporate bonds over the years. In 2020, their equity allocation stood at less than 20%.

Indeed, because of their volatility (see exhibit 2), equities are not fully suitable for:

  • Defined benefit pension funds, the majority of which are closed to new entrants and often in run-off mode (i.e., no new rights are accumulated)
  • Defined contribution members who now face the full investment risk without the guarantee available to defined benefit members
  • Insurance companies under increased solvency capital requirements that particularly concern volatile investments.

As an alternative, many institutional investors started investing in UK Gilts and listed high-quality corporate bonds. However, as can be seen in exhibit 3, their nominal yields have steadily fallen over the last 20 years (with the exception of 2008/2009 during the height of the Global Financial Crisis). Consequently, for the last few years, real yields have been either low or negative (depending on the maturity).

The solution

Private markets can be an attractive substitute to listed equities and bonds. 

  • Private equity (PE) is defined as capital invested in companies that are not publicly traded. This asset class includes traditional leveraged buyouts and venture capital (VC) as well as infrastructure (infra) equity and direct real estate (RE) investments.
  • Private debt or credit is defined as capital invested in the debt of private companies. Private debt is not traded or issued in an open market. It generally includes asset classes such as corporate lending (to SME and mid-market companies), real assets such as infrastructure debt and commercial real estate (CRE) debt as well as structured solutions such as mortgage and capital risk sharing funds.

Indeed, private debt and equity offer a number of advantages over their listed equivalents.

  • Higher returns, captured through an illiquidity premium
  • Lower volatility and a lower market beta (which for insurance companies under risk-based capital regulation is crucial)
  • Potentially more targeted environmental, social and governance (ESG) oriented investments (based, for example, on line-by-line selection of well-defined projects)
  • Lower immediate liquidity as most of these assets are valued once a month or once a quarter and are usually held to maturity to avoid liquidation costs.

The investment universe

Here is an overview of the investment universe:

Source: BNPP AM, November 2021

Strategies for investing in private credit and debt

In practice, asset managers have developed different types of investment strategies to meet investors’ objectives when entering the private credit and private debt universe:

  • Diversified private credit strategies generally aim to incorporate various types of real asset debt and corporate lending with some structured finance sub-asset classes and to capture a credit illiquidity premium. They offer a blend of senior and mezzanine investments, countries, currencies, credit ratings and liquidity. They can be structured as cash-flow matching portfolios and can be suitable for mature defined benefit pension schemes (with a large majority of retirees) as well as insurance companies operating under risk-based capital regulations (capital requirements are less punitive because private debt assets have a lower volatility than their listed equivalents).
  • Diversified private markets strategies add exposures to private equity, direct real estate and infrastructure equity to a diversified private credit portfolio. They aim to capture a blended illiquidity premium. They are structured as alternative growth engines and are suitable for defined benefit pension schemes with active members and defined contribution pension plans with long time-horizons. They typically offer higher expected returns with lower volatility levels than their listed counterparts do.

Because of their nature, these strategies are customised to individual client needs and have varying features when it comes to:

  • The investment universe can be narrow (for example, focused on corporate lending) or wide (including semi-liquid asset classes such as leveraged loans)
  • Fund design – they can be open-ended or close-ended, unitised as a Luxembourg RAIF or a UK-based LP
  • The strategic asset allocation (SAA) can be directive or just indicative, with loosely set ranges allowing for active asset allocation over time
  • They can be evergreen or established only for a pre-determined amount of time
  • They can rely on a fund-of-funds structure or include only single investments.

For all these reasons, we believe diversified private credit or private market approaches have a strong edge over investing in single asset classes as well as over listed asset classes. 

Other benefits

Beyond the much improved risk/return profile that can be obtained at the portfolio level by combining different private debt and private equity sub-asset classes, it is worth noting that there are other important benefits:

  • Diversified private credit and private market strategies can be structured as bundled solutions with streamlined custody, depositary, fund and loan administration services. This helps avoid the complexity of managing multiple illiquid asset mandates and funds with different service providers. Many institutional investors that pursue a diversified approach are struggling with the back-office requirements needed to efficiently manage the complex capital call schedules, as well as principal and interest payments.
  • They often set deviations ranges around the SAA to smooth the relative value based asset allocation process across the investment universe: the hunt for the illiquidity premium often leads to breaches of even moderately strict SAA ranges. This reduces the need for constant rebalancing that is more common with liquid asset classes.
  • Depending on the manager and the investment vehicle, the solutions also benefit from holistic risk, liquidity and cash management by a single team, ensuring consistency and coherence.
  • Diversified private debt and private market solutions have established strict governance arrangements that enhance the flexibility of the SAA and allow for innovation and nimble assessment of opportunities as they arise. For example, an annual or semi-annual investment committee meeting can be convened to assess new asset classes, e.g. credit risk sharing, as they arise or full discretion can be afforded to the asset manager.
  • Last but certainly not least, ESG and climate change considerations can be embedded in the private debt and equity transaction filtering and selection processes. This provides investors with greater confidence in the quality of their investment portfolios, and a better alignment with pension scheme members and policyholders.

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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