Asset owners are concerned about valuations in private markets, however supply and demand dynamics continue to support growth.
Private markets aren’t a panacea
Private markets can help asset owners address the funding gap they face, however it’s not a panacea, says Danelle Singer.
Efficient allocation key to private markets
Asset owners can allocate more to private markets by freeing up portfolio risk and reducing costs in other areas of the portfolio.
Canadian pension funds are firmly focused on private markets as they continue their hunt for returns in challenging markets. But they’re not exactly a panacea to the funding gap facing asset owners according to participants in our recent Private Markets Roundtable featuring three members of Invesco’s Investment Solutions team: Kate Browning, Alternatives Investment Specialist; Paisley Nardini, Strategist; and Danielle Singer, Head of North America Client Solutions.
In this segment of the discussion, they shared their insights on where returns and valuations are headed as well as new opportunities emerging in the evolving private markets space. Read the full discussion.
What’s the return forecast for private markets?
Paisley Nardini: Entering 2022, traditional assets, such as listed equities and fixed income, face headwinds according to Invesco’s Capital Markets Assumptions (CMAs). Global equities are estimated to deliver 6% annualized return, meaningfully lower than the 12% they have historically delivered. This declining return expectation is pushing asset owners further into private markets. In contrast, our CMAs show direct real estate and private equity expected to deliver 9% to 11% returns over the next decade. This will go a long way in helping asset owners meet their return goals.
Danielle Singer: That being said, private markets aren’t necessarily a panacea to the funding gap many asset owners face. There are still inherent risks, especially as some of these strategies reach further and further for returns and push into more esoteric assets. Going forward, asset owners also need to consider the dispersion in returns from manager to manager in private investments – historically, performance dispersion has been significant in this space compared to more traditional strategies.
What about valuations in private markets? Should asset owners be concerned?
Kate Browning: We are certainly keeping an eye on valuations – there is a lot of capital chasing these opportunities. But despite historic levels of dry powder, supply and demand dynamics seem generally supportive of this growth. We continue to monitor valuations through various lenses, including relative to history and public proxies, and our view on current valuations remains neutral to positive.
What are the biggest opportunities you see in private markets today?
Paisley Nardini: Almost every conversation we’re having with Canadian asset owners touches on growing their allocation to real assets to achieve higher income levels and fight inflation. As markets have added more depth via niche strategies and market segments, investors also require greater sophistication to manage more dynamic or opportunistic allocations.
We also see opportunities to allocate more efficiently across portfolios that hold private market investments. As allocations increase, so do portfolio costs and overall volatility – which can be offset with a barbell approach. By freeing up portfolio risk and cost budgets using lower cost, systematic or passive index strategies, the portfolio may afford a higher private market allocation. This prudent balance can be especially important for those who report to a board or internal stakeholders.
We employ a fundamentally based “building block” approach to estimating asset class returns. Estimates for income and capital gain components of returns for each asset class are informed by fundamental and historical data. Components are then combined to establish estimated returns. Here we provide a summary of key elements of the methodology used to produce our long-term (10-year) and medium-term (5-year) estimates. Fixed income returns are composed of; the average of the starting (initial) yield and the expected yield for bonds, estimated changes in valuation given changes in the Treasury yield curve, roll return which reflects the impact on the price of bonds that are held over time, and a credit adjustment which estimates the potential impact on returns from credit rating downgrades and defaults. Equity returns are composed of; a dividend yield, calculated using dividend per share divided by price per share, buyback yield, calculated as the percentage change in shares outstanding resulting from companies buying back or issuing shares, valuation change, the expected change in value given the current Price/Earnings (P/E) ratio and the assumption of reversion to the long-term average P/E ratio, and the estimated growth of earnings based on the long-term average real GDP per capita and inflation. Volatility estimates for the different asset classes, we use rolling historical quarterly returns of various market benchmarks. Given that benchmarks have differing histories within and across asset classes, we normalize the volatility estimates of shorter-lived benchmarks to ensure that all series are measured over similar time periods.
(i) IIS develops CMAs that provide long-term estimates for the behavior of major asset classes globally. The team is dedicated to designing outcome-oriented, multi-asset portfolios that meet the specific goals of investors. The assumptions, which are based on a 10-year investment time horizon, are intended to guide these strategic asset class allocations. For each selected asset class, we develop assumptions for estimated return, estimated standard deviation of return (volatility), and estimated correlation with other asset classes. For additional details regarding the methodology used to develop these estimates, please see our white paper Capital Market Assumptions: methodology update.
(ii) This information is not intended as a recommendation to invest in a specific asset class or strategy, or as a promise of future performance. These asset class assumptions are passive, and do not consider the impact of active management. Given the complex risk-reward trade-offs involved, we encourage you to consider your judgment and quantitative approaches in setting strategic allocations to asset classes and strategies. This material is not intended to provide, and should not be relied on for tax advice.
(iii) References to future returns are not promises or estimates of actual returns a client portfolio may achieve. Assumptions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell securities. Forecasts of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. Estimated returns can be conditional on economic scenarios. In the event a particular scenario comes to pass, actual returns could be significantly higher or lower than these estimates.
(iv) Indices are unmanaged and used for illustrative purposes only. They are not intended to be indicative of the performance of any strategy. It is not possible to invest directly in an index.
(v) The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.
All investing involves risk, including the risk of loss.
The opinions referenced above should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.
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