Private assets

The future of diversification

October 24, 2024 - 3 min read

Private assets, long the preserve of institutional investors and high net worth individuals, are increasingly on the tongues of wholesale investors. Not only do they hold up the promise of diversification in a world that is increasingly too complicated for a simple 60/40 allocation, but recent performance and growing ease of access as a result of regulatory changes such as ELTIF 2 make them ever more attractive. But, while adding private assets to a portfolio is increasingly easy to do, wholesale allocators have additional considerations such as investment horizons and liquidity needs that must be taken into account if they are to mitigate the risks and successfully harness the growth in AUM that is expected.

Having grown steadily over the past 20 years from under $1 trillion at the turn of the century to more than $13 trillion last year, private markets are now expected to double over the next five years.¹This growth is anticipated despite current headwinds, including higher interest rates that have raised the cost of capital and tightened credit, as well as slower private equity exit activity². For example, the number of company sales in 2023 fell by 15% in France and 37% globally—the worst level since the global financial crisis—due to limited IPO and M&A activity.³

This growth will be fuelled by wholesale investment for two reasons. First, there is a significant imbalance in the allocation of private asset AUM. In Europe, regulators have tried to address this skew by revising the ELTIF regime. The introduction of ELTIF 2 – and the generalisation of evergreen funds - this year is expected to act as a starter’s pistol for the industry. At the end of 2023, there were 95 ELTIFs registered for sale across Europe, managing overall assets of €13.6 billion. By 2026, AUM in EMEA-managed private asset funds is expected to increase threefold to around €35 billion.⁴

But it is not only regulation that is driving this push—there are also compelling asset allocation reasons to increase exposure to private assets. First and foremost, private asset strategies seem to be a great fit for pension products given their extended investment horizon and lack of liquidity need. Besides, as can be seen from historical data, the typical moderate European wholesale portfolio is fairly well spread out across equities and fixed income.

Composition of a typical moderate European wholesale portfolio without private assets

Source: Natixis IM Solutions, Preqin - 2024

To test the impact of private asset allocations on portfolio risk and return, we used vintage index data for the main private asset strategies from the past decade, de-smoothing their risk to allow for a holistic overview of portfolios’ true risk.

The impact of private asset exposure on risk and return

PE Buyout, infra in equal proportions, based on historical vintage returns Sep 2013 to Sep 2013 in EUR

Hypothetical risk-return postioning of portfolios with varying private asset exposure

Natixis IM Solutions, Preqin – Using de-smoothed data in EUR

While the data clearly shows that adding private assets can be beneficial to the overall composition of a portfolio, there are several caveats to consider.

Challenges for Wholesale Portfolios

The primary challenge is that the dispersion of returns within private assets is much wider than with publicly traded asset classes. As a result, the importance of manager selection is far greater since the gap between high and low performers is larger.

But strategy selection isn’t the only consideration. There are four other factors to keep in mind when thinking about how to include private assets in a portfolio:

Limited Data: While data availability from private asset providers is improving, it remains challenging to have full visibility into holdings, making it difficult to model within portfolios.
Valuation: Private assets are valued less frequently, making traditional risk measures such as volatility less accurate. As a result, assets can appear less risky than they actually are.
Illiquidity: Private assets are harder to sell than listed assets. While this comes with certain benefits, it can make rebalancing a portfolio more difficult in the short term and may affect its long term asset allocation.
Cash Management: Managing private assets’ capital call and distributions elevate the need for an active management of cash in investors allocation

Nevertheless, illiquidity and cash management will be mitigated by new evergreen products offering liquidity windows to their investors and avoiding capital calls. As a long-term trend, it is not without risk, but for those with the expertise and risk appetite to navigate the changing landscape, it also offers significant opportunities.

¹ Source: FT, Preqin, Natixis IM 2024 – excludes FoF and secondaries

² In recent years, private market investments were effectively “self-funding,” because capital distributions tended to outpace any required capital commitments. As exit activity slows, so investors will need to find alternative sources of capital to meet capital commitments, which can create both a liquidity and portfolio construction dilemma.

³ Ignites Europe - Eltifs 'have not lived up to immense expectations': Scope

⁴ Ignites Europe - Eltifs 'have not lived up to immense expectations': Scope

Marketing communication. This material is provided for informational purposes only and should not be construed as investment advice. Views expressed in this article as of the date indicated are subject to change and there can be no assurance that developments will transpire as may be forecasted in this article. All investing involves risk, including the risk of loss. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.