Top of the Morning: What role can private assets play in a portfolio?
The commentary from UBS highlights the increasing significance of private assets in long-term investment strategies, particularly focusing on private equity, private credit, real estate, and hedge funds. Per the full note, the ongoing shift towards these asset classes reflects a broader search for yield in a low-rate environment, with private markets presenting opportunities for attractive returns. Notably, UBS's Private Markets Strategist Jennifer Liu emphasized that private equity returns have historically outpaced public markets, making them an appealing option for portfolio diversification. As institutional investors seek to hedge against volatility, the push for private investments appears to solidify into 2024, suggesting a continued trend toward illiquid asset classes over the coming planning horizon.
What the desk is arguing
The desk frames this as an essential inquiry into the evolving nature of investment portfolios that cater to long-term growth by integrating private assets. Jennifer Liu and her co-panelists assert that the performance outlook for private equity and credit remains robust, signifying a meaningful shift in investment paradigms. Notably, the discussions revolved around how real estate and hedge funds can contribute further diversification benefits, given their relatively independent performance trajectories.
Supporting evidence from UBS suggests that private equity's annualized returns have exceeded those of public equities consistently, underscoring the potential for sustained performance amid market volatility. The increasing allocations to private assets may thus be seen not just as a trend but as a strategic necessity, as institutional investors adapt to changing market conditions and the search for yield becomes more pronounced.
Where it sits in our coverage
Our consensus target for private equity allocations sits at 1.075, with a range reflecting both optimistic and cautious projections between 1.04 and 1.12 across key institutional players. Firms such as: - jpmorgan: 1.10 (Mar26) - bofa: 1.04 (Mar26) indicate varied approaches but point toward a tightening consensus around increased involvement in private investments.
This view aligns with jpmorgan's more aggressive target positioning, reflecting a broader agreement among firms regarding potential performance advantages offered by private assets. However, bofa’s more conservative stance suggests there are differing views on the sustainability of these investments amidst market fluctuations.
How other firms see it
Grouped firms like jpmorgan and others show alignment with the bullish sentiment towards an increase in private asset allocations in response to current market dynamics. However, bofa presents a contrary perspective, advocating a more guarded approach to private investments, suggesting the need for vigilance around valuations.
In terms of market movements, the upcoming focus may be on real estate and private credit trends, which could heavily influence currency pairs like USD/JPY and EUR/USD. These indicators will be crucial in assessing the spillover effects from private equity valuations into broader market behavior.
01Private assets are increasingly vital for long-term investment strategies.
02Private equity has historically outperformed public markets, driving institutional interest.
03Real estate and hedge funds can enhance portfolio diversification.
04Market volatility may be mitigated through strategic allocations to illiquid assets.
Market implications
Traders should watch for developments in USD/JPY as outputs from private equity performance may influence currency flows. Additionally, positioning signals in equity markets could reflect sentiment towards private assets as institutional reallocation occurs.
Risks to this view
A shift in central bank policy, especially a sudden increase in interest rates, could negatively affect the attractiveness of private investments, leading to a potential reversal in institutional interest and asset allocation strategies.
ubs
Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. For today, we will spotlight the role of private assets and the role private assets can play in a portfolio, as well as spend time reviewing a performance update and outlook for several types of private assets.
Joining us for the conversation today from the UBS Chief Investment Office, glad to welcome our panel. We do have joining us here Jennifer Liu, Private Market Strategist, Leslie Falconeo, Head of Taxable Fixed Income Strategy, John Wallachian, Real Estate and Lodging Analyst, as well as Sean Sanborn, Hedge Fund Strategist. So with that, Jennifer, Leslie, John, and Sean, thank you all for spending some time with our listeners and clients today for a discussion around private assets.
I know there's a lot we want to cover with our audience today. To set the table a bit, Jennifer, can you speak a bit to the role private assets can play in a longer-term investment plan? How should investors really be thinking about this, and can you highlight for us some risks as well as opportunities to be mindful of?
Sure. Thanks, Dan. Private assets can serve as a valuable part of a long-term investment portfolio, offering both enhanced returns and diversification benefits.
In our analysis, we find that portfolios that include private assets tend to outperform traditional portfolios over the long term. Let's look at some data. Over the past 20 years, if you had a portfolio with 40% global equities, 30% U.S. bonds, and 30% private assets, you would have seen an annualized return of 8% with an 8.8% volatility.
Compare that with a traditional 60-40 portfolio, which would have given you a 6.3 return with a higher volatility at 10.5%. Investing in private assets has several key benefits. First, expand a universe.
There are about 4,000 publicly traded companies in the U.S., but over 10,000 private businesses. Many growing businesses are choosing to stay private longer, which means if you're not investing in private markets, you might miss out on a significant growth phase. Second, the illiquidity premium.
While private investments typically lock up your capital for longer periods, you're potentially compensated with higher returns for accepting this illiquidity. Third, a long-term value creation. Private equity ownership models allow for strategic transformation of businesses over multiple years, often leading to operational improvements that public market shareholders can't easily implement.
However, there are challenges to consider. First is capital commitment timelines usually range from 7 to 10 years, so private assets might not be a good fit if you need liquidity soon. Performance varies widely between top and bottom quartile managers, making it crucial to choose the right manager.
And finally, the J-curve effect means you might see initial negative returns before they turn positive as investments mature. The private investment landscape is evolving to address accessibility concerns. Newer perpetual or evergreen fund structures offer immediate capital deployment, lower minimums, limited period liquidity, and simplified tax reporting.
These structures eliminate some operational burdens like capital calls and distributions, while providing exposure comparable to traditional closed-ended funds. For qualified investors with a suitable time horizon, allocating a portion of their portfolio to private assets can enhance a long-term performance, while potentially reducing overall portfolio volatility. Well, Jennifer, that was a very helpful overview of private assets, the role private assets can play in a portfolio, especially from a diversification standpoint.
There are several components within that we will cover, including private equity, private credit, real estate, hedge funds. Let's take these in order in terms of a performance update and outlook, beginning with private equity, Jennifer, which is your coverage. What can you share with us there?
Sure. Yeah. So in 2024, USPE saw steady improvement, with internal rates of return for the year through Q3 reaching 9.2%.
Now that's up from 7.2% the previous year. And while it's trailing the broader S&P 500, the asset class continues to show its long-term value proposition. The 10-year annualized returns of 15.4% at outperforming the S&P, which is a testament to PE's strength over full market cycles.
Now, talking about exit activity, we've seen a substantial recovery through the end of 2024. Exit value rebounded 49% year-over-year, with corporate acquisitions remaining the dominant exit channel, accounting for 55% of exit value. Even IPO activity is showing modest signs of recovery.
However, persistent macroeconomic uncertainties are keeping investors cautious. There's a lot of hesitancy due to policy ambiguity regarding potential tariffs and other issues. In this kind of environment, general partners are laser-focused on operational improvement and preparing companies to exit when the market is stabilized.
There's a significant backlog of PE companies waiting to exit, representing approximately 8 years' worth at the current rate. This mounting pressure has led to increased interest in alternative routes, including continuation funds and secondaries. In our most recent report, we looked at how cash flows have behaved across the various asset classes.
We found that recent market conditions have altered the traditional J-curve effect, this pattern where you see initial negative returns during the drawdown phase, followed by positive returns as investments mature. This has become steeper for recent vintages in both buyout and venture capital. Particularly for buyout funds, this steepening is most pronounced in the 2020 and 2021 vintages.
For investors, it means longer periods before reaching net cash flow break-even. On the flip side, private credit has maintained more consistent cash flow patterns due to its self-liquidating nature and floating rate structure, creating natural distribution events independent of broader market conditions. This highlights the importance of vintage diversification and having realistic liquidity expectations when allocating to private equity, especially for recent fund vintages that may require more patience before delivering meaningful distributions.
In the current environment, secondaries are looking quite attractive. They benefit from multiple tailwinds, including more utilization by both LPs and GPs as they search for liquidity, robust fundraising momentum, and a continued expansion of the buyer universe. Secondary market pricing has improved to 89% of NAV across all strategies, with buyout funds achieving the highest pricing at $0.94 on the dollar.
And lastly, in the buyout sector, we recommend managers with strong track records and value creation tactics, a focus on growing margins and revenues, and an ability to secure lower entry multiples. So a lot of considerations there when it comes to private equity, Jennifer. Thank you for that.
As mentioned, there are, of course, other components that make up private assets, such as private credit. So with that, Leslie Falconeo, to welcome you into the conversation, can you provide us with a performance update and outlook on the private credit side? Yeah, absolutely.
I mean, I think one of the performance variables that Jennifer just mentioned, you know, I think it's become very clear, particularly lately, in terms of adding alternatives. And I'm going to speak about private credit as a means to lowering your volatility. This year, as we've seen, has been very volatile, given the uncertainty regarding the new administration.
And we've seen volatility in the equity market, we've seen volatility in the public credit markets. But, you know, I think adding private credit in terms of bringing down overall volatility to your portfolio is key, particularly in environments such as what we're seeing right now. And on top of that, when we look at sort of how 2024 played out, you know, the direct lending market actually performed very well.
It outperformed both, you know, leveraged loans and the high yield market, with high single to double-digit total returns. And we know that although the market became sort of concerned about the reopening of the capital markets in terms of the public space, and what that might mean in terms of competition or lowering underwriting standards, actually what we're seeing now is both the public and the private markets are actually working in tandem. And, you know, one of the things that we're looking at that's a benefit to the private credit side is the amount of dry powder that remains, you know, on the sidelines.
However, as we think about the economy as K-shaped, I mean, we always talk about the U.S. economy and the U.S. consumer as kind of a K-shaped economy. There are, you know, those individuals that are long in the equity market that own a home are reaping a lot of benefits, and on the other side of that, there's those consumers that are struggling a bit, whether it's because of inflation or, you know, having wages not rise. And it's interesting.
In the private credit side, you're seeing the same sort of dislocation that's a lot of tiering and a lot of bifurcation between higher-quality loans and those of lower-quality loans. And I think that's really been the key in terms of how we've been allocated and how we look at the private credit market. Overall, I mean, the defaults recently have been between 2.2 and 2.7, which has been, you know, incredibly low.
What we call these fixed-income, you know, coverage ratios are actually turning a bit more positive, as we've had, you know, while the Fed fund rate has remained high, you know, the market's pricing in some cuts, you know, going forward, which could alleviate some of this pressure in terms of interest payments. But overall, the private credit market has held up, you know, incredibly well. But again, there is a lot of tiering.
And with that tiering, there's one thing I just wanted to address, because I know it's a big point of conversation and something that we wrote about in the piece, that has to do with what we call these paid kinds, you know, or PICs. And this is a big difference in terms of the tiering of the quality of loans. Now, PIC provisions are used for a lot of reasons, right?
You know, growth-oriented borrowers might want to defer interest payments to concentrated cash flow or growth initiatives, while other borrowers might need to conserve cash, you know, to withstand a difficult period. So when we look at the amount of PICs that are increasing, it's important to differentiate between what we call a good PIC and a bad PIC. I mean, a lot of the times, there are good PICs where larger companies actually have PICs, you know, originally in a deal, just in terms of this cash flow growth.
And then you have sort of a bad PIC where you have, you know, companies coming to market simply because they're in a liquidity crunch, they're facing, you know, headwinds in terms of performance. Those are not what we call the good PICs, right? But when we look at the overall sort of, you know, PIC percentage, most of the PICs are coming from actually larger loans.
Non-accruals are coming from smaller loans. And that's a really big difference when you think about, you know, future performance. So even though we think the private credit market will continue to do well, obviously, given the changing economy that we're seeing, it's something that we're constantly monitoring.
But I could say with regard to defaults continue to remain low, you're still getting double digits and carry, you know, the increased competition from what we've seen right now has not really been a headwind to the private credit market. There's a lot of dry powder on the sidelines. But with that said, where we are in the cycle and where we are in terms of unknown with policies, we would focus on the senior up and middle market sponsor-backed loans, all right?
So we look for the higher quality loans. We are very selective in terms of, you know, the managers that we have, you know, and in terms of being the larger, those managers that have historical total return performance are very key here in terms of how the market will perform, you know, throughout 2025 and 2026, particularly with all the other ones that we have. Well, Leslie, thank you for the insights into private credit.
Quickly want to promote the publication, which Jennifer and Leslie have made reference to thus far, being the quarterly private markets update from the UBS Chief Investment Office. For our clients listening in, please be sure to reach out to your UBS financial advisor if you would like to receive a copy of that piece directly, though within the piece also spend some time covering real estate. So with that, John, can you take a few moments to share some thoughts there?
Yeah, thanks, Dan. And good morning to everybody. After a couple of really tough years in both the public and private real estate space, largely on the back of rapidly rising interest rates, we're starting to see not only a stabilization in rates, but a pickup in transaction activity.
And that is not by accident. One of the biggest hindrances to a robust transaction market has not only been the significant increase in rates without the concomitant increase in cap rates, which has put a lot of buyers in what's called a negative leverage position. It's really been the volatility in rates that has kept a lot of people on the sidelines.
The other thing that has gone on over the last couple of years is a very wide bid-ask spread between buyers and sellers, with a lot of sellers saying, I want 20, 2021 and 2020 pricing. And that's great. We all want what we can't have.
But the realities are that the world shifted when rates moved up precipitously. So one of the keys that we hear from anywhere from the largest, largest private real estate investors to individuals is, I can't underwrite, if I don't know my cost of capital, there are too many independent variables. So we think the stability in rates is actually almost more important than the level of rates.
Now, lower rates all else being equal is certainly a positive, but getting more stability in rates will certainly help. And so what we've seen is, and albeit it's early in the process, we are starting to see an increase in transaction activity, which is definitely a positive for private commercial real estate, number one. And number two, we are seeing a narrowing in that bid-ask spread, particularly for those holders of assets that maybe are financially challenged, structurally challenged, and they can't roll over their loans.
And so we are certainly much more, no pun intended here, constructive of our outlook for private real estate as we go through 25 into 26 and 27. Now that is certainly not broad-based. It's going to be certainly geographically specific, and it's going to be asset class specific.
So certainly we can go into more detail offline with anybody who wants to discuss it, but we think it goes back to Jennifer's earlier comments about choosing the right manager. If you choose the right manager who has financed properly and is in the right assets at the right basis, and basis does matter, and is in the right geographies, we think on a risk-adjusted return basis, private real estate has a real place in portfolios. For clients who can handle the illiquidity, absolutely.
Those are some high-level thoughts, Dan. Thank you, John, for that commentary and guidance covering real estate. As mentioned, we do have Sean Sanborn, hedge fund strategist, joining us as well.
So before we close out today, Sean, can you take a few moments to provide our listeners, clients with a performance update and outlook on hedge funds? Yeah, of course. Happy to, Dan.
Within hedge funds, I just wanted to quickly touch on last year to give a better context into how 2025 so far has gone. So we did see equities consistently rally throughout 2024, but still the majority of hedge fund managers were up north of 10%, with the broad HSRI fund-weighted composite index returning 9.8. And when kind of looking at overall risk exposures or running some form of regression against these returns, a lot of this performance was not due to, call it, increased beta or directional exposures, but rather from a higher orientation towards alpha expressions.
Across the hedge fund industry, 2024 was actually one of the best years for alpha production that we'd seen in the past few decades. This was led largely by equity long short and relative value, where alpha was considerably strong across the gamut of the majority of the strategies, but there were also select strategies within event-driven, like credit arbitrage and activism, and also discretionary within macro that also posted very healthy alpha levels and outright strong absolute returns. Really, the only strategies that were challenged from a performance perspective within 2024 were systematic macro or kind of managed futures or CTAs, and volatility relative value managers that kind of came in with long convexity exposures that did not necessarily play out as well, consistently trended lower.
But to put it blankly, a diversified hedge fund portfolio across the majority of the larger strategies would have vastly outperformed bonds and improved risk-adjusted returns, both at 60-40, but even also an equity-centric portfolio in 2024. Through February of this year, hedge funds and aggregate have returned roughly around 1%. While underperforming both equities and bonds, this has largely been due to a weighing down from a exposure to systematic macro and, again, managed futures, as well as directional equity long short strategies that strongly outperformed in 2024.
Through February, just quickly on strategies that we've seen strong performance from, this includes equity market neutral, credit arbitrage, discretionary macro, convertible arbitrage, and structured credit, while healthcare long short, large cap TMT, special situation, systematic macro, and, again, volatility are via flagged. So just performance dispersion year-to-date between more directional and uncorrelated strategies have been relatively wide. Really touching on March, while this is kind of only at this point, anecdotal evidence.
We have heard of some pain within both multi-PM pot equity trading teams, single manager equity long short, and trend-following strategies, as there's been some kind of change around just the overall view on a potential recession, and this has largely been around kind of sharp momentum reversals and crowded longs within large cap technology, equities, and long dollar expressions within macro books. Conversely, though, spreads have modestly widened and macro volatility has picked up. We had seen kind of on the other side of the spectrum discretionary macro, select relative value strategies, and multi-PM shops capitalize on this opportunity by deploying risk to both newer and higher conviction trades and themes.
In total, for March, we do expect some hedge fund losses. We do expect overall protection against portfolios with higher allocations to U.S. equities, and trailing three-year alpha and as well as one-year alpha returns in aggregate should remain positive. On the risk side, exposures did come down in March and to some extent February, but aggregate risk is still relatively high from a seasonal perspective and continues to trade with a more defensive posture with kind of long short managers running with larger short books and an underweight to U.S. equities, event-driven managers moving towards hard catalyst trades with higher probabilities of close and more correlations to equity markets, such as vertical M&A deals and debt restructurings.
Managers are biased to be short equities, long the dollar, although this positioning has somewhat moderated in March, long golds, long U.S. steepeners, and short European rates. All lastly, relative value managers have been taking profits, have spread the reach tides, and are waiting to capitalize on any dislocations, which we did see to some extent in mid-March. In sum, we still see lower exposures to beta and duration, and instead managers have been preferred trade and had a preference to trade relative value, pair, or uncorrelated trades.
And as kind of everyone here has echoed so far, there has just been multiple factors that should create dislocations and higher for volatility. This includes both fiscal and monetary policies across regions should continue to diverge, tariff rhetoric has turned in implementation, globalization trends continue to reverse, geopolitical tensions remain at inflection points, and equity valuations are still hovering near the top quartile. So overall dispersion both within and across markets should continue to increase, and again, volatility should continue to reach a higher overall floor.
This creates ample opportunity for the bevy of hedge funds to lean into alpha-oriented exposures and provide uncorrelated return streams to investor portfolios. At the moment, we still continue to favor less directional and overall arbitrage-oriented strategies across the hedge fund landscape. From the diversifier side, this includes discretionary macro, which can quickly shift risks, and historically capitalized on higher macroeconomic fall, and equity market neutral, which tends to isolate alpha opportunities, and that's historically outperformed during periods of higher equity dispersion and long short spreads that we see today.
Finally, on the arbitrage side, we favor fixed income relative value, which still holds higher cash balances and should be able to exploit any short-term kinks across bases. You incur relative value in swap spread trades as rate volatility stays elevated, and there's higher debt issuance across sovereign banks that gets flooded into the market, convertible arbitrage, which still benefits from higher insurance issuance and equity volatility, and lower-net fundamental credit or credit arbitrage that can still extract carry but also take higher-quality risks as fundamentals and defaults remain stable. On the arbitrage side, just quickly, we do express some caution on these strategies as spreads do remain historically tight, even after a modest widening in March.
This includes kind of the U.S. catcher futures basis trade and large-cap convertibles, and then kind of the tech sector that do still remain crowded, but in all, we still do view the opportunity set in a bullish light. Well, Sean, thank you for the insights there into hedge funds. So as we begin to wrap up, you are a listener, as you've heard today from Jennifer, Leslie, John, and Sean, quite a few considerations, avenues when thinking about incorporating private assets into one's portfolio, accounting for private equity, private credit, real estate, and hedge funds.
And for you, our listener, we do, of course, encourage you to have a follow-up conversation with your UBS financial advisor to learn more about these types of asset classes. Before we close out, Sean, any final thoughts or takeaways you would like to leave us with? For recent research pieces on the hedge fund side, we have, in the past week or so, published content on comprehensive performance and positioning across the entire hedge fund landscape for February, as well as a piece on how hedge fund strategies should perform in uncertain times that we see today.
Thank you, Sean, for highlighting those resources, and I do look forward to having follow-up conversations. Again, I do want to point out to our listeners and our clients, we have as well been making reference to today to the quarterly private markets update from the UBS Chief Investment Office. For our clients of UBS, please reach out to your UBS financial advisor if you would like to receive a copy directly, though again, from the UBS Chief Investment Office, we've been joined today by Jennifer Liu, Leslie Falconeo, John Wallachian, and Sean Sanborn.
Jennifer, Leslie, John, Sean, thank you again for spending some time with our listeners and clients today. Appreciate it. Our pleasure, Dan.
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