PRIVATE MARKETS 2020

Portfolio outcome: Capital growth

Capital growth-focused investors have traditionally relied mainly on public equities to reach their return targets. As an aging bull market encounters increasing headwinds, some investors worry that a heavy concentration in public equity investments will not achieve their goals. The market sell-off in late 2018 was a reminder of the damage extreme volatility can inflict on a portfolio and of the elusiveness of true diversification.

Investors with the requisite long-term horizon may therefore consider shifting a portion of their public equities allocation to capital growth-focused private assets. In doing so, they may benefit from taking a broad view of the relevant investment types available in today’s private markets. While some capital growth asset classes serve as analogs to existing public equity allocations (buyout and venture capital), others allow for the introduction of novel risk factors into the portfolio (greenfield infrastructure), while others can serve to express views on future market turmoil (distressed debt/special situations).

The optimal makeup and sizing of allocations will depend on the specific needs of the investor. However, each of the asset classes we discuss can play an important role in a healthy portfolio.

Mapping the private capital growth asset classes

Below, we show a market-weighted breakdown of the private capital growth 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.

Capital growth composition vs Risk decomposition.

 

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.

Portfolio impact of a market-weighted private capital growth allocation

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 an 80%/20% public equity/bonds portfolio with a 3% 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 47%. We use that illiquidity budget to size a market-weighted allocation to the private asset classes, funding the re-allocation from the public equity budget.

Public and Private Market Capital Growth Portfolio.

 

Source: BlackRock, January 2020. Capital weights computed using capital flow data as of 12/31/2020. Risk calculated using BlackRock’s risk management platform, Aladdin, and exposures as of December 31, 2020, 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 will capture a significant return premium of around 200 bps. This reallocation does come with an increase in projected volatility, as capital growth investments in the private market come with significant economic volatility and leverage. That said, we find that the projected return earned per unit of risk increases, suggesting that risk-adjusted returns improve alongside absolute returns. Note that this portfolio can be improved with the use of portfolio optimization, which may further increase risk adjusted returns.

Current trends in the private capital growth asset classes

Buyout

  • Buyouts are the biggest subset of the private equity investment universe. Strategies vary, but nearly all are predicated on active management of private companies.
  • On the heels of strong equity performance and muted market volatility, private equity buyout funds have witnessed record growth in capital flows, bringing dry powder to nearly US$757 billion as of December 2019, according to Preqin. For most investors, buyout continues to be the principal asset class in their private market allocation.
  • As the business cycle extends into its eleventh year, investors are focused on valuations in anticipation of a potential downturn and / or heightened equity market volatility. Valuations seem elevated with enterprise value (EV) to EBITDA multiples for buyouts in the US at approximately 11.2x as of Q4 2019, while European EV to EBITDA multiples for buyouts are approximately 11.0x, according to Preqin. On a relative basis to public equities, however, buyouts still look attractive. We are wary of investments with excess leverage, but still see opportunity in businesses with defensible franchises, proven management, and clear paths to continued growth.

Venture capital

  • Venture capital refers to equity investments in corporations with long-term growth potential. Investments generally take the form of direct or convertible equity, with capital currently concentrated in technology-based opportunities.
  • Venture capital has enjoyed some of the best returns in the asset class’s history over the past 10+ years, as it has enjoyed lucrative exit opportunities in a ripping public equity market. The strong performance of the technology sector explains much of this strong performance. The S&P 500 Technology Index has outperformed the broader S&P 500 by 130% from January 2010 to June 2019.
  • One concern with today’s venture capital investments is the limited realized value back to the investors; put another way, there has been a considerable amount of contributions into funds with limited distributions. Most of the value accrued to investors is derived from the paper value of existing holdings: distributions from post-2008 venture capital vintages total approximately $63bn as of Q1 2019 as compared to $152bn of drawdowns, with approximately $220bn remaining that has yet to be paid out, according to Preqin.

Greenfield infrastructure equity

  • Greenfield infrastructure equity refers to financing for pre-operation infrastructure assets. These assets provide essential services to the public in sectors ranging from power and energy to transportation, communication, water and social needs such as student housing. Greenfield investments may entail risk related to construction, operational improvements and regulatory/jurisdictional regime.
  • Investors have been drawn to greenfield infrastructure equity for a variety of reasons, including yield compression earned from the de-risking of projects, cash flow generation, the high global demand for new infrastructure, and the addition of new uncorrelated risk factors to their portfolios.
  • While the increasing number of buyers for the asset class has driven future return projections lower recently, we are still broadly positive on the relative value dynamics of the asset class. A primary reason for this view is the asset class’s limited exposure to traditional capital growth risk factors (i.e., public equity market beta) as well as the continued demand for new infrastructure projects around the world.

Opportunistic real estate equity

  • Opportunistic real estate equity consists of investments in higher risk, often pre-construction, real estate, where returns are generated mainly through construction, development, and/or building improvements. Opportunistic real estate funds tend to focus on land, development and redevelopment in order to realize their potential. Such investments are typically highly levered (60%+ LTVs).
  • Value creation in opportunistic real estate is based on a number of variables: timing the markets correctly (including both the capital markets and local real estate markets), anticipating legislative changes (e.g., zoning, planning approval), government privatization decisions, and/or finding the right buyers for unique investment types (among others).
  • One of the largest advantages of opportunistic real estate is the ability to finance new assets that fill gaps created by macroeconomic and sectoral trends.
  • Our analysis shows that vintage year performance has a correlation to entry cap rates of 0.67 from 2001 to 2013, implying that 45% of the variation in returns can be explained by timing of the economic cycle. As such, investors should monitor their exposure to this strategy during periods of low cap rates.

Distressed debt / special situations

  • Distressed debt/special situations refers to investments that have an element of distress, dislocation or dysfunction and/or where there may be gaps in capital availability and may include securities that have either defaulted, are under bankruptcy protection, or are under distress and moving towards the aforementioned situations in the near future.  Debt can also be considered distressed if the borrower fails to maintain certain covenants, such as a coverage ratio.
  • Since 2009, investors have committed nearly US$240 billion to the asset class with approximately US$70 billion of dry powder remaining, roughly double the amount of dry powder available during the Global Financial Crisis, according to Preqin.
  • In the last five to six years, defaults have been relatively limited outside of the energy space in 2015-16, which was largely driven by the fall in commodity prices in 2014-15. At the same time, many of the large bankruptcies/restructurings of the past decade (such as Lehman, TXU, and Caesars) have mostly played out. As a result, the returns in the space have been constrained.
  • Capital dedicated to distressed/special situations needs to be somewhat patient as the opportunity for outsized returns can be narrow (quick rebound following a sharp sell-off). Therefore, maintaining an allocation to the distressed space may be needed even in a benign environment to capture favorable full-cycle IRRs.
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