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The era of low rates has suppressed yields from traditional public market income-generating assets, such as high yield bonds, and sent investors searching for income from private funds.
Private income-generating assets can offer investors several advantages over their public market counterparts. First, private debt transactions, both on the corporate and real assets side, are highly negotiated and thus can include a variety of items that provide downside protection in the event of default. There is also a potential return premium offered above public markets.
Allocating to illiquid enhanced income asset classes can increase risk-adjusted returns in the portfolio. Within enhanced income, more equity-like asset classes are able to enhance a portfolio primarily through increasing absolute return levels, while simultaneously adding novel risk factors (e.g. brownfield infrastructure and value-added real estate). Others offer significant yields with more downside mitigation potential than is available in public markets at the same levels of return (e.g. core real estate, subordinated real estate debt, and mezzanine).
Direct lending may also be used to deliver enhanced income depending on the risk-return of the underlying credits (e.g. second-lien loans) and structure (e.g. how the loan portfolio is financed). The specifics of the individual portfolio (yield targets, public allocation, etc.) will dictate the exact mix of these assets, but each can be powerful in building a better portfolio for enhanced income investors.
Below, we show a market-weighted breakdown of the private enhanced income asset classes and the risk characteristics of a proportionate allocation to them. We use the closed-end fund universe to set the market weights and the Aladdin economic risk model for the risk decomposition.” (I assume “Aladdin economic risk model” is not a proper noun.)
Source: BlackRock, January 2020. Capital weights computed using capital flow data as of 12/31/2019. Risk calculated using BlackRock’s risk management platform, Aladdin, and exposures as of December 31, 2019, from the trailing 72 months of data. Sources for capital weights: Thomson One, Preqin, LifeComps, NCREIF. See the Appendix and Disclosures at the end of the Private Markets 2020 paper for additional details, including the indexes used to represent each asset class. There is no guarantee that the capital market assumptions will be achieved, and actual risk and returns could be significantly higher or lower than shown. Hypothetical portfolios are for illustrative discussion purposes only and no representation is being made that any account, product or strategy will or is likely to achieve results similar to those shown.
Having mapped out the available investment choices, we now explore the potential risk-return advantages of a diversified allocation across these asset classes. As an illustrative base portfolio, we consider a 60%/40% public equity/bonds portfolio with a 5% annual spend. According to the analysis presented in The Core Role of Private Markets in Modern Portfolios paper, this portfolio conservatively has an illiquidity budget of 31%. We use that illiquidity budget to size a market-weighted allocation to the private asset classes, funding the re-allocation pro-rata from the public equity and public bond budgets as both asset classes may contribute to income generation, e.g. dividend equity or high yield bonds.
Source: BlackRock, January 2020. Capital weights computed using capital flow data as of 12/31/2019. Risk calculated using BlackRock’s risk management platform, Aladdin, and exposures as of December 31, 2019, from the trailing 72 months of data. Sources for capital weights: Thomson One, Preqin, LifeComps, NCREIF. See the Appendix and Disclosures at the end of this piece for additional details, including the indexes used to represent each asset class. There is no guarantee that the capital market assumptions will be achieved, and actual risk and returns could be significantly higher or lower than shown. Hypothetical portfolios are for illustrative discussion purposes only and no representation is being made that any account, product or strategy will or is likely to achieve results similar to those shown.
Our conclusion is that the portfolio that allocates its illiquidity budget to private markets should capture a significant return premium of over 120 bps. Additionally, the private market allocation diversifies the risk of the 60/40 portfolio, through the addition of a variety of novel risk factors. The combination of enhanced return and lower risk leads to an increase in projected return earned per unit of risk. Note that this portfolio can be improved with the use of portfolio optimization, which may further increase risk-adjusted returns.