Private markets encompass real estate, infrastructure, private equity and private credit – the land, buildings, systems and services on which our cities and countries depend; investment in business and ventures that are not traded on the stock exchange; and the provision of debt directly to businesses or projects that is not traded on an exchange. Each of these sub asset classes offers different risk and return characteristics.
This has long since been a valuable component of pension investment portfolios. Opportunities in property have widened to include student accommodation, residential housing, logistics, and development assets, which offer the potential for capital appreciation over the long term, combined with cash flows from rents.
Investments in infrastructure have also been embraced by the pension investment community, particularly local government; it is highly valued for its ability to generate predictable, stable and reliable cash flows. Many such investments are natural monopolies and have built-in inflation escalators.
Thanks to the wide range of companies now under private equity ownership, investing in private equity is an increasing component of overall asset allocation among institutional investors. Instead of focusing on quarterly earnings, the average private equity fund will own a company for five to seven years, allowing management teams to drive through operational or strategic improvements in order to maximise revenue and increase profits. Private equity is fundamentally about creating value through the transformation of companies.
Private credit affords investors another means of expanding their opportunity set. While regulatory constraints have curtailed the amount that banks have been willing to lend to businesses and projects, the provision of debt from the private sector has seen substantial growth. Private credit offers a diverse array of strategies and a number of advantages, particularly in a low return environment. Target return, risk and liquidity are among the most important considerations; these strategies offer the potential to achieve different objectives, with differing degrees of liquidity.
As the chart below illustrates, it is widely accepted that an allocation to private markets can improve the risk-adjusted return potential of a long-term investment portfolio. Here we see the potential to benefit from an illiquidity premium of between 200 and 300 basis points above listed assets, which is a very substantial opportunity.
Importantly, private markets offer low correlation of returns to traditional asset classes in public markets, and if this is built into a portfolio, there can be very attractive risk/return benefits.
Many pension professionals will be aware of the exemplary performance of the Harvard and Yale university endowments, which have invested material proportions of their portfolios in private markets for the past two decades, and have consistently achieved very attractive annual returns. These markets need not be off-limits to UK DC schemes. Secondary markets are developing across these sub asset classes and we are working with a number of investors to develop solutions that enable private markets to be part of DC portfolios, leveraging our deep sector experience and expertise in strategic asset allocation, implementation risk, and portfolio risk management.
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