Private markets

Beyond the hourglass: Spotlight on private assets

13 November 2023

While central banks are still combating the post-pandemic inflation wave, investors are wondering how to position their portfolios amid elevated economic and geopolitical uncertainty. Can private markets offer a ray of hope, and help investors navigate the turbulent tides by making their portfolios more robust?

By Nikola Vasiljevic, Ph.D., Head of Quantitative Strategy, Zurich, Switzerland; Lukas Gehrig, Quantitative Strategist, Zurich, Switzerland

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below. All data referenced in this article is sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.

Key points

  • It is important to highlight that private market investments tend to be longer-term, and therefore, investors should be willing and able to accept longer lock-up periods
  • In reality, economic cycles cannot be avoided, and their impact is the price that investors (in private markets) must accept to harvest the illiquidity premium
  • To achieve a desired stable level of strategic asset allocation in private markets, investors need to commit capital every year. In other words, they need to diversify not only across different (sub-) asset classes, but also across vintages.

Persistent macroeconomic volatility remains one of the main worries, and one of the key performance drivers for all asset classes. As a result, investors are increasingly concerned about the implications of a more fragmented, precarious world. 

Whispers of time: Understanding macro drivers

Knowing this and acknowledging investors’ aversion to risk and ambiguity, we turn our attention to two burning questions that we aim to address in this article:

  1. What can we learn from past economic cycles regarding the performance of different asset classes? 
  2. How can private markets help investors to effectively diversify their portfolios and boost returns?

We consider six traditional, liquid asset classes: cash, developed government bonds, developed investment grade bonds, global high yield bonds, developed equities and commodities. These asset classes are the essential building blocks of any multi-asset class portfolio. They cover a broad range of investment opportunities and allow investors to tap into different sources of return in the form of income and/or capital gain.

In addition to these “core” asset classes, we consider illiquid alternatives such as private markets (i.e., private debt, private equity and private real estate) and hedge funds. We note that – due to the lack of liquidity – these “satellite” asset classes are less transparent than public market investments. Therefore, any estimation procedure is subject to uncertainty and should not be taken at face value.

Monetary policy regimes in the spotlight

We calculated the annualised nominal quarterly performance for liquid and illiquid investments in different monetary policy regimes between Q3 2004 and Q2 2023. This sample period is determined by balancing data availability and the macroeconomic cycle dynamics. We considered three US monetary policy regimes: 

  • Expansionary monetary policy: characterised by rate cuts, covering the periods Q3 2007-Q4 2008 (deflationary bust and a major recession caused by the Global Financial Crisis) and Q3 2019-Q1 2020 (disinflationary bust and a brief sharp recession caused by the COVID-19 pandemic), 
  • Accommodative monetary policy: characterised by stable and low interest rates, spanning the periods Q1 2009-Q3 2015 (disinflationary growth) and Q2 2020-Q4 2021 (pandemic-induced economic stimulus),
  • Contractionary monetary policy: characterised by rate hikes, covering the periods Q3 2004-Q2 2007 (inflationary boom), Q4 2015-Q2 2019 (interest rate normalisation on the back of near full employment and reflation) and Q1 2022-Q2 2023 (stagflation). 

In the chart, the performance of each asset class in different regimes is represented by vertical bars.

Monetary policy regimes impact all asset classes

Annualised average quarterly performance of selected liquid and illiquid asset classes over the whole period and in different US monetary policy regimes from Q3 2004 to Q2 2023

Sources: Bloomberg, Preqin, Barclays Private Bank. Data accessed in October 2023, last observation point June 2023

Falling rates

Our first finding is that – over the last two decades – only cash and liquid high-quality bonds have posted positive average returns during monetary easing episodes (which typically coincide with recessions). Historically, developed government bonds have significantly outperformed other asset classes in the “falling rates” regime, validating their “risk-off” or “safe-haven” status.

As one might expect, the riskier assets such as equities and credit performed the worst during “risk off” episodes. Commodities and illiquid assets have also lagged, albeit to a lesser extent on average. Among the latter, the least negatively affected asset classes were private equity and private debt.

Rising rates

A very different outcome is observed during periods of monetary tightening. In this scenario, liquid risk-on assets, hedge funds, and private markets in particular, have exhibited relatively strong performance. 

Real assets such as commodities and private real estate have posted their highest average returns in this monetary regime. As interest rates tend to rise in sync with inflation, real assets are often included in a well-diversified portfolio as inflation hedges.

On the other hand, liquid high-quality bonds lagged significantly in this monetary policy regime.

Stable and low rates

When monetary policy is accommodative most asset classes tend to do well. This regime is typically characterised by stable growth and inflation that is either in line with, or slightly below, the central bank’s target. Equities, credit, hedge funds and private markets particularly shine in such an environment. 

Long-term perspective: Illiquidity premium

Additionally, we calculated the annualised average return over the full sample (represented by black circles in the chart). 

Only cash and developed government bonds exhibited positive average performance in all three monetary policy regimes. However, safety and below-market risk come as the cost of below-market returns. Over the full sample, cash is actually the worst performing asset class. Moreover, the average real cash rate (i.e., adjusted for inflation) was -0.8%. This means that staying on the sideline would have significantly eroded wealth over the past two decades.

The best performing asset classes were public and private equities. Private debt (private equity) delivered an illiquidity premium over global high yield bonds (developed equities) of 2.4% (3.0%) per annum. 

However, it is important to highlight that private market investments tend to be longer-term. Therefore, market and funding liquidity risk management is an additional element that needs to be considered when investing in private assets. Indeed, investors who were willing and able to accept longer lock-up periods benefited the most from 2004 to 2023.

Charting new paths with private assets

Our analysis above indicates that each asset class has a specific role in a portfolio, depending on its sensitivity to inflation and growth. 

In particular, the past two decades show that there are pockets of value within private markets irrespective of the monetary policy regime. As such, private markets appear to be a particularly valuable building block in a multi-asset class portfolio.

Although the evidence of strong private markets performance in the accommodative and contractionary regime is convincing, one could question the role of private markets during expansionary monetary policy episodes. 

In reality, as private markets are genuine long-term investments, economic cycles cannot be avoided. This seems to be the price that investors must accept to harvest the illiquidity premium. 

Taming economic cycles with time diversification

To gain further insights into the investment dynamics in private markets, it is necessary to consider the performance of different private markets over time and across a sufficiently large set of private market funds.

To this end, we explored the performance of different funds within four important private market segments: buyouts, venture capital, private debt and private real estate (see the chart). We calculated the median net internal rate of return (IRR) and the performance dispersion across funds (as the interquartile range) for vintages 2004-20211.

The median net IRR varied substantially over time; however, it was positive for almost all vintage years across the four asset classes. Averaged over the considered vintage years, the median net IRR is 8-15%, depending on the private market segment. 

The net IRR dispersion also exhibited some variation over time, typically being higher during crisis periods. In other words, performance in any monetary policy regime can look significantly different from the numbers presented above in this article, depending on the fund selection. Choosing the right private markets segment and selecting the above-average funds (e.g., in the first or second quartile) is essential for investment success (albeit nothing is ever guaranteed). 

Private markets performance varies substantially over time and across funds

The median net IRR shows the overall trend, whereas the interquartile range provides a robust statistical measure of the cross-sectional performance dispersion for selected private markets from 2004 until 2021. The interquartile range is a robust statistic that captures the middle part of the return distribution (i.e., the range between the 25th and 75th percentile), measured over more than 100 funds.   

Sources: Bloomberg, Barclays Private Bank. Data accessed in October 2023, last reported vintage year 2021

Selecting threads and weaving a private markets tapestry

The final element in our analysis is to break down private debt, private equity and private real assets into sub-asset classes. The private markets universe offers a very wide set of opportunities, and putting each asset class under the microscope can bring valuable insights. 

We calculated the average annualised return, autocorrelation-adjusted annualised volatility2 and worst historical loss for 18 sub-asset classes split between the three aforementioned categories. In contrast to the previous section – where we worked with funds data – here we consider Preqin’s quarterly benchmark indices and measure performance as total return. 

Our analysis indicates that private debt strategies have had the most stable return and lowest volatility (see the left panel in the chart). However, they also suffered the largest drawdowns in 2008 (albeit they were quick to recover thereafter). This example also illustrates that investors should think carefully about the risk measure they use when analysing investment opportunities.

Private equity strategies span a wide range of risks and returns, and therefore offer most selection opportunities. A similar conclusion holds true for private real assets. This is not surprising since these two broad asset classes have by far the most assets under management of any private markets.    

Private markets offer a rich spectrum of return and risk  

The average annualised total return versus autocorrelation-adjusted annualised volatility (worst historical loss) for selected private market strategies from Q3 2004 until Q2 2023 are presented in the left (right) panel. The span of risk-return trade-offs for various private equity, private debt and private real assets strategies is captured by the shaded cyan, purple and teal areas, respectively.

Sources: Bloomberg, Preqin, Barclays Private Bank. Data accessed in October 2023, last observation point June 2023

Turning today’s anxieties into tomorrow’s hopes

Uncertainty is unsettling and can keep investors away from markets for too long. However, considering potential macro scenarios and taking measured risk often benefits investors in the form of higher long-term returns. 

Private markets represent the ultimate frontier (depending on an investor’s personal circumstances) when it comes to long-term investing. To achieve a desired stable level of strategic asset allocation in private markets, investors need to commit capital every year. In other words, they need to diversify not only across different (sub-) asset classes, but also across vintages. 

Moreover, our historical analysis of the performance dispersion among funds indicates that tactical views can be addressed by a diligent and skilful fund selection. 

By combining all these elements, investors could harvest the illiquidity premium over the long term, and open the door to additional returns, without necessarily having to worry too much about the macroeconomic environment. 

Outlook 2024

What’s in store for investors in 2024? Despite lingering uncertainty and volatility, find out why it’s not all doom and gloom.