The shift to private market financing means that investors can only access the full opportunity set by allocating to private markets. The sector and regional split of many public markets is also not representative of the characteristics of the asset class as a whole. This can skew outcomes. Infrastructure debt is a good example. The public infrastructure bond market is dominated by utilities and US issuers, whereas the infrastructure debt market is far more diverse by sector and region.
3. Reduce risk (volatility and/or risk of loss)
Returns from many private assets are less volatile than public markets, which appeals to many investors. However, in some cases, this is down to valuation methodologies, which can smooth reported price variability.
This is well known in private equity and real estate, but also occurs in private debt. For example, while some private debt holdings (including Schroders) are fully, independently, marked-to-market using prevailing market yields, others value at cost-less-impairment, and others use discounted cash flow style approaches.
Not all private asset classes or structures exhibit smoothed valuations. The assets in semi-liquid funds are valued monthly or quarterly in accordance with rigorous accounting standards, such as US GAAP and IFRS 13. To ensure these valuations provide an accurate picture of the fund's holdings, they are often audited by reputable audit firms and regularly reviewed by internal pricing committees.
Private assets are less volatile and they may also be less risky, but to assess that second point it is necessary to dig into the asset class, and strategy itself. There are many qualitative factors which need to be taken into consideration (see full paper for some examples).
A more holistic approach to understanding risk is required. Real estate risk is nearer to equities than bonds, despite what standard volatility analysis might suggest. Private equity is highly diverse. The slightly higher leverage in large cap buyouts means that it would be reasonable to treat the sector as riskier than public equities, but a qualitative case can be made for small and mid-cap buyouts to be given more favourable treatment. Individual venture capital investments may be risky, but portfolios have been remarkably resilient and can also gain in value even when markets are crashing. Private debt too is highly diverse. There are elements which are less risky than corporate bonds, especially in asset-based finance, but the spectrum is wide.
Figure 4: Private assets have different underlying risks to public markets
4. Add diversification benefits by introducing differentiated drivers of returns
Given their differing underlying exposures and return drivers, private assets offer diversification benefits compared to public markets. These vary by asset class and market. Given issues with valuation approaches, a better way to consider the relationship between public and private returns is to look through to the underlying exposures and focus on differentiated drivers of returns, not statistical estimates of correlation.
