Creative Solutions in a Returns-Challenged World: Private Capital

This excerpt, taken from Balentine’s 2016 Capital Markets Forecast, discusses how the Private Capital building block can help bridge the gap between what returns clients need and what public markets currently offer.

A key theme in Balentine’s 2016 Capital Markets Forecast is that public market returns face strong headwinds going forward. Valuations in equities and bonds are near all-time highs which create difficulties for clients who seek real return. It is therefore Balentine’s job to bridge this gap, taking intentional risks in portfolios to smartly increase the expected return for clients.

One way Balentine aims to achieve this is through a diverse allocation to private capital. As with all private investments, illiquidity is a necessary prerequisite to access what we consider unique exposure with diverse ways of adding value. This advantage should stand alone and not just be a product of financial engineering. This advantage and exposure is captured in two ways: return source diversification and medium of investment.

Return source diversification refers to the risks a portfolio is exposed to, as well as the portion of the return derived from capital gains versus yield. Public markets typically generate returns through exposure to the equity risk premium for stocks and credit and interest rate risk for bonds. These assets also provide the capital gains (stocks and high yield bonds) and yield (investment grade bonds and dividend-paying stocks) which make up the total return. Exposure to private markets increases both the number of risk premiums and the traditional sources of total return. An example of this is a private investment in reinsurance. The insurance risk premium provides a return for those willing to accept the risk of loss for the steady income of premiums.

Diversifying the make-up of total return also becomes much more impactful within private markets. For example, when investing in real estate, the spectrum ranges from core, which are trophy buildings in gateway markets, to opportunistic, which can be half-vacant neighborhoods needing a fair share of work. While both are investments in real estate, the different risks result in vastly different return profiles. These different drivers and sources of return not commonly found in public markets provide the sustainable advantage we seek in private capital.

A second advantage comes from the medium of investment – how and where the manager is able to invest. While typical public market investments include access to investment grade and high yield bonds as well as the public equity of a company, private placements can invest up and down the capital structure of a firm. This allows a manager to be more creative in adding value and is made possible by accepting the illiquid nature of a private capital investment.

There is no shortage of risks present when investing in private capital. While each investment has its own idiosyncratic risks, four macro risks affect private capital as a whole. Understanding and planning for these risks are key to successfully implementing private capital.

Accessing private capital depends greatly on asset level and should balance investor intentions with three critical aspects: access, diversification, and fees.

When building a Private Capital allocation, we always take into account a client’s liquidity profile, type and amount of assets, need for return (yield versus capital appreciation), and risk profile. These will ultimately drive the size and makeup of the allocation and how it is built up over time.

Please download our 2016 Capital Markets Forecast to find out the specific areas of Private Capital we are emphasizing in client portfolios as creative solutions to bridge the gap between the returns offered in today’s market and what clients need.