Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Private markets deal with the ‘fear effect’
While the downward pressure of inflation rates and rising interest rates pushed public markets to a spectacular loss in 2022, the private markets “demonstrated more resilience” and outperformed public strategies across the board – sometimes by thousands of basis points, according to a new report from Hamilton Lane. Buyout outperformed the S&P500 by nearly 2,050 basis points, while infrastructure and real estate beat the FTSE All Equity REITs Index by more than 3,400 basis points.
“Before we lose the naysayers to a rant about why this can’t be possible… note that portfolio weighting mattered a great deal,” the report says. “Heavy exposure to growth and venture resulted in greater losses in portfolios. This makes sense, since those strategies are invested heavily in technology, which also had the greatest declines in the public markets. Lo and behold, there’s a rhyme and reason to this investing stuff!”
Looking back on the history of private assets, the report also found that they outperformed during both the dot-com bubble collapse and the GFC, as well as the subsequent recoveries.
“There is little advantage in trying to time investments over the course of the cycle (and as a practical matter, it’s impossible for most investors to execute),” the report says. “It may be boring and cliched to say ‘invest consistently in private markets and you’ll be fine’, but boring and making more money sounds a lot better than exciting and making less money.”
While it’s tempting, as the report notes, to attribute the outperformance solely to the infrequent valuations of private assets – and a supposed lack of scrutiny applied to private assets when they were valued – the data shows that valuations are “pretty fair across most private market sectors”.
“In the private markets world, one overriding refrain was a hallmark of 2022: valuations in private assets are bogus (the word “bogus” here is a kinder, gentler placeholder for the actual words used),” the report says. “The topic dominated nearly every meeting, every conversation. How can public markets be down 20 per cent and private markets only be down something like five per cent. There were references to Madoff and Ponzi schemes, to fraud, deception, obfuscation, and countless other words we can neither pronounce nor understand.”
But the report notes that most exits from private assets were at or above valuation – which tells you “that valuations can’t be disassociated from reality” – while the majority of general partners surveyed for the report, representing US$2.6 trillion in combined AUM, saw strong revenue growth across their portfolio companies through 2022. And not everything in the public markets went down, either; 30 per cent of the component companies of the S&P500 had positive returns in 2022, while 20 per cent were up more than 10 per cent.
“It’s definitely a possibility that valuations will be coming down, just as they did in 0221 and 2008, but not because they are artificially high today,” the report says. “They will come down if the public markets continue to drop. All those pundits telling you that private market valuations are too high and will drop? They are making an implicit assumption that they aren’t telling you; they are assuming the public markets are going to drop in 2023.”
“They may. If they do, then it is likely because economic conditions are worsening (recession?) and revenue/earnings at private companies will suffer, as will valuations. That is a prediction we are not prepared to make.”
But while private valuations might be mostly inured to falls in the public markets, the same can’t be said for fundraising, which is currently suffering from the denominator effect – where illiquid assets coming to form a greater share of institutional portfolios as liquid asset values fall – as well as “the fear effect”, where lower public markets “almost invariably” cause some investor pullback in illiquid investments. While 2021 was a record year for fundraising, 2022 will be “down quite a bit” and Hamilton Lane has not observed capital raising moving at the same rate of increase or on pace with the deployment”.
“Look at the market share that the largest funds are taking in recent vintage years,” the report says. “On one hand, this can be viewed as another sign of a market peak, but we think the more important point is that it heightens the problem for general partners seeking to raise capital.”
“First, it means that there is more pressure on smaller funds because so much capital is flowing to the largest funds. However, for the largest funds, it raises the question of whether they will be able to raise equal amounts, let alone an increase to which they’ve become accustomed.”
