A muted return outlook for traditional assets has more investors seeking out alternative return sources.

If you’re banking on continued strong returns from a traditional asset allocation, you may end up being very disappointed in the years ahead, according to a recent note issued by Morgan Stanley. With many stock indices trading at all-time highs and bond yields at generational lows, Morgan Stanley (MS) is forecasting a sobering 2.8% annualized return over the coming decade for a traditional portfolio composed of 60% equities and 40% fixed income – about half the average over the last two decades.
 
Constructing a portfolio with a diverse set of performance drivers is always a smart idea, but it takes on increasing importance in a muted return environment for traditional assets. Against the current backdrop, a growing number of investors are considering private equity for the first time – not solely as an “alternative” investment, but rather as a core component of a well-constructed portfolio that can drive long-term performance and help investors meet their goals. Private equity (PE) has generated 597 basis points of outperformance over a 20-year period and 489 basis points over a 15-year period versus the S&P 500. If MS’ projections pan out, the comparative value from private markets could make a critical difference, especially for investors heading into retirement over the next decade or so.
 
Moreover, PE’s outperformance relative to public markets tends to increase during market downturns – the asset class generated some of its strongest returns in recession-year vintages, including 2001, 2002, and 2009. And the significant dispersion between top- and bottom-performing PE funds means that investors able to access private funds in the top two quartiles would have experienced far better results.image: some of pe's strongest vintages began investing during downturns

The declining opportunity set in public equities is another factor driving more investors to consider private markets. Over the past 20 years, the number of publicly listed U.S. companies has nearly halved, from 8,090 in 1996 to around 4,397 in 2018, despite the fact that U.S. GDP has doubled over that same period.¹ Meanwhile, the average age of a public company has increased from roughly 12 years to almost 20. The implications of these trends are profound: Companies that remain public are older and more mature, on average, than listed firms in years past. The fact is that much of the economic growth today is taking place outside of the public markets and the cost of staying 100% liquid is getting worse.

Investors tend to overestimate the amount of liquidity that is needed to maintain allocations to private market investments. According to a recent BlackRock study, investors should have greater tolerance for private market investments than is conventionally understood. The study found that institutional investors with high spending rates – as high as 8% of the portfolio – can sustainably manage allocations up to 20% in private investments. Hence, advisors and clients following the “4% Rule” – widely considered a conservative spending rate – could manage reasonable allocations to private markets.

We often remind investors that private equity’s illiquid nature is what enables PE managers to create value – they can pursue strategic initiatives that require several years to execute without worrying about quarterly earnings calls and the resulting short-termism that afflicts so many public companies. As a result, committing to a PE fund forces an investor into a buy-and-hold discipline and places the exit decision (when to sell a portfolio company) in the hands of experienced professionals who are closest to the assets. This prevents emotion-driven decisions to sell during volatile markets – a well-known wealth destroyer.

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1) Source: Cambridge Associates US Private Equity Index, as of March 2019.

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Nick Veronis

Nick Veronis

Nick is Co-Founder and one of the Managing Partners of iCapital Network, where he oversees Research and Due Diligence. Nick spent 11 years at Veronis Suhler Stevenson (VSS), a middle market private equity firm where he was a Managing Director responsible for originating and structuring investment opportunities. He holds a BA in economics from Trinity College and FINRA Series 7, 79, and 63 licenses. See Full Bio.