How to build dependable diversification with private assets
Institutional investors have caught on to the diversifying power of private assets, but is there even more to it than meets the eye?
Private assets are growing in popularity, and the 2021 Schroder Institutional Investor Study shows that this is increasingly due to their ability to diversify.
But there may be more to this ability than meets the eye.
In a new series of articles, we intend to go beyond the “bread and butter” of diversification in private assets, exploring aspects that deserve more attention.
The only “free lunch” – but what’s in it?
As Nobel Prize winner Harry Markowitz said, “diversification is the only free lunch in investing”. Diversification should, in theory, reduce risk without reducing return commensurately.
What does that mean exactly?
Not all diversification is created equal. For listed investments, approaches to portfolio construction and diversification are mostly quantitative, not least because of the availability of a broad amount of data. Performance of different asset types can be monitored – often live – and the contribution to overall portfolio volatility can be tracked. However, correlations vary widely over time, and can shoot up, especially during times of market stress.
In private assets, there is much less data available. Valuations are monthly or quarterly instead of daily or intraday. The data is less suited for mathematical modelling, as it is generally based on valuations (analysis-based) rather than market prices (transaction-based).
While valuations are real in the sense that these are the valuations that investors book for their investments in private assets, they depend on the applied methodologies and can introduce certain biases. These can understate volatility and correlations, which in turn can result in misleading modelling outcomes for portfolio construction and diversification purposes.
Therefore, diversification in private assets is more suited to a qualitative approach, with limited use of quantitative data.
With all of the above caveats, private assets have historically had a volatility-reducing effect on portfolios, especially in times of market stress. This is not only related to valuations, but also driven by fundamental differences.
The fundamental differences in private assets
The cash flow of most real estate and of some infrastructure investments are contract-based, which significantly reduces the correlation of income to the overall economy and can add to dependable diversification. The same applies for insurance-linked investments.
The private assets investment model with closed-ended fund structures, locked-in capital and multi-year investment and holding periods helps to remove a lot of the investment behaviour you might expect from public market cycles.
This also contributes to more dependable diversification. Private asset fund managers can patiently await the right opportunity at the right time, or exit investments when the market allows for it. It also allows private asset investors to be buyers when others are sellers and to sell when markets show signs of overheating. This ability to go against the trend is a key advantage of private assets.
To adjust for the less cyclical investment and cash flow patterns in private assets, private asset returns are sometimes compared to listed investments by applying the cash flow patterns of private investments to listed indices. This approach is supposed to help compare “apples with apples”, however, investors in listed markets do not invest the same way as investors in private markets. Such comparisons can underestimate the diversification effect of private assets.
Mixing your return drivers
Private markets have grown and matured over the last two decades and are expected to represent an $8 trillion industry by the end of 2021. Today, there is a multitude of private asset strategies to choose from, providing investors with a variety of return drivers.
By combining different private asset classes - such as private equity, venture capital, private debt, infrastructure, etc. - investors can get exposure to very different return, risk and liquidity profiles. But they can also make use of different underlying macroeconomic and industry-specific return drivers.
For example, investments in renewable energy infrastructure can provide additional diversification to private equity, to which energy related investment is rarely exposed. Similarly, investment in privately negotiated insurance linked investments (ILS) carry fundamental risk and return drivers that are mostly uncorrelated with other private asset investments. In ILS, risk profiles are linked to natural disaster (for cat bonds and related investments) and the longevity of the population (for life insurance related investments).
Real estate can provide additional diversification to listed and private equity portfolios. Where listed equities and private equity are typically “leading indicators”, real estate is a “coincident indicator”. Real estate has been a good diversifier of equity risk because equities move depending on forecasts for the economic cycle. Real estate movements are coincidental or even lag changes to economic growth expectations.
Back stage pass – accessing restricted investment
Private assets can introduce entirely new areas. This applies in particular to private asset investments for which there are no comparable listed equivalents. For example, young, strongly growing start-ups accessed via early-stage venture capital (VC) are simply not accessible through stock markets.
Facebook only became a publicly listed company at a $100 billion valuation when it held its initial public offering (IPO) in 2012. More and more fast growing companies, especially in tech, have decided to stay private for longer ever since. In China, access is often even more exclusive.
Investing in new, renminbi-listed companies in mainland China is not possible through stock markets for most international investors. However, through certain particular regulated fund structures, international investors can get access to renminbi-denominated private investments, even before they list on local stock markets or are acquired.
Of course, an exclusive investment could still be highly correlated to listed equity, but seed and early stage investments often have little or no revenue. This means little correlation to the economy. For these investments, other factors determine value creation, as the company develops and grows.
Investment specific (idiosyncratic) risk
Different private asset strategies can offer diversification across underlying macroeconomic or industry-specific risk and return. However, as many investments share exposure to macroeconomic or industry themes, another dimension of diversification can be valuable. Investment specific, or idiosyncratic risks, are particular to individual investments and typically less (or not at all) correlated to other investments, even if they share a strategy or region. Idiosyncratic risks can be a very powerful tool for diversification.
An idiosyncratic risk might be the execution risk related to the refurbishing, reconfiguration and repositioning of a hotel investment. It could also be the execution risk of an acquisition-led industry consolidation strategy, for a private equity backed buyout fund.
Idiosyncratic risk can be found where there is an attempt to capture the so-called “complexity premium”, where a complex or unique situation is matched by the right set of skills for the management of the asset.
As a further example, venture capital investments, are risky at the single investment level, but much less so in a well diversified venture portfolio. This is particularly the case because venture capital investments have a high share of idiosyncratic risks, which are lowly correlated among each other.
While an early stage venture portfolio requires several hundred underlying investments to be sufficiently diversified, this number is lower for investments that are less risky on a single asset level. Nevertheless, even the lowest risk investments require diversification, as even a very low risk of default is not zero and therefore is better diversified away to the extent possible.
Opportunities in the “long tail” of private assets
Attempts to improve diversification are often constrained by a limited investment universe. This is especially the case for listed investments, where portfolios typically track a benchmark and where their maximum achievable diversification is often dictated by the composition of the index.
It can also be an issue for private market investors, especially for investors that focus on the largest deals within a private asset strategy, where deal flow is comparatively limited.
Interestingly, the largest private asset transactions represent 50% of the deal volume but less than ~5% of the number of transactions. It follows that the “long tail” of private assets - and the other half of deal volume - represents about 95% of transactions. It should be noted that this is across private assets. In private equity, the number of transactions that represent 50% of volume is as high as 99%.
Example: Private Equity deals by size and rank ($m – log scale)
Source: Preqin, Schroders 602741
Given its high number of transactions, the long tail of private assets allows investors higher selectivity and a more active approach. The long tail allows for a more balanced industry sector allocation than the more limited deal flow at the larger end of the market would provide for. This also ties in especially well with the comments on diversification through idiosyncratic risk, mentioned earlier. Indeed, deviation from the overall market is necessary to achieve a more balanced portfolio.
A word on market timing in private assets
Diversification across time, through vintage years, is a key element for most private asset investors. In primary fund investments, capital is typically locked-up for a 2 to 5 year investment period, which provides some additional built-in diversification over time. A challenge for institutional investors can be making new fund commitments in difficult market environments, to ensure continuous vintage year diversification.
While timing the market in private assets is generally not possible, investors should carefully monitor if any market segments show any signs of overheating, as has been the case for venture capital in 2009 and for large buyouts and real estate in 2006-2008. The Schroders Capital Data Insights team has built a quantitative indicator, the “FRI” indicator which can help provide some guidance in this context.
Varied and dependable diversification
Diversification has risen steadily in importance with every month, quarter and year that valuations in liquid markets have hovered at historic highs. Moreover, investors have been living with the fact that the link between valuations and fundamentals has grown weaker. That is to say, “technical” factors of supply and demand in price action have been significantly influenced by the policy backdrop. Diversifying away from these factors is therefore, a practical step. Private markets offer - variously - reduced cyclical exposure, greater idiosyncratic risk, restricted access and a breadth of opportunity set that we believe is underappreciated by many institutional investors.
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