The Ongoing Evolution of Direct Lending
As demand for non-bank capital increases and yields remain attractive on a historical basis, direct lending continues to grow as an asset class.
It is hardly a secret today that institutional investors are allocating a growing share of their portfolio to private markets. US state and local pensions alone more than tripled their allocation to private markets and other alternative assets between 2001 and 2022, reaching 27.3%.1 Demand for private assets continues to expand, with investors broadly anticipating additional growth moving forward.2 In large part, the spark for this trend can be attributed to the success of large university endowments, whose sizable allocations toward private markets set the stage for growth. However, asset allocators seeking to replicate the endowment model must also consider the broader, unintended implications of this approach—namely, elevating liquidity risks in the portfolio. This underscores the role that liquid alternatives play in a diversified portfolio.
The rise of the endowment model, bringing with it an increasing share of illiquid assets in portfolios, necessitates that investors put greater emphasis on ex-ante risk management. To be clear, this has happened for good reasons. Investors have increasingly sought greater choice and, in seeking to build portfolios with a diverse mix of asset classes and investment strategies, turned to private markets. These assets are an important component of a diversified portfolio and became especially attractive during a period of ultra-low interest rates.
But with this shift to illiquid markets comes the potential for hidden concentration risks to develop in a portfolio. Thus, investors should be looking at risk through a wider lens. Rather than focusing solely on volatility, investors need to think about risk in multiple dimensions, including their exposure to liquidity and rebalancing challenges that may arise in an uncertain global environment. As investors observed in 2022, a concurrent decline in equity and fixed income asset prices left some portfolios with an overcommitted book in illiquid assets. The need to draw down on liquid investments for the purpose of funding distributions or other obligations widened the imbalance between liquid and illiquid allocations, creating additional challenges for CIOs.
Institutional investors should also note that not all alternatives are made equal when it comes to their liquidity profile. In private markets, some assets might have an investment horizon of three to five years. Others, such as farmland and timberland, may extend well beyond that timeframe.
Constructing a diversified portfolio that is genuinely diversified in its asset classes, strategies and liquidity profile calls for consideration of liquid alts like systematic macro strategies and managed futures. Liquid alts could offer substantial diversifying returns in a world where traditional asset classes come under stress. This could also be true in a world where few asset classes deliver on their expected returns, leading investors to seek diversification through sources of return that can cushion the blow by reducing downside risk and the overall volatility of a portfolio. To achieve this, investment strategies must be agile and disciplined, two things that have contributed to a re-emergence in demand for process-driven and quantitative investing. Facing an uncertain global outlook, a growing number of investors have viewed quantitative techniques as a means of generating returns in a volatile, ever-changing world.
Source: Bloomberg and PGIM Wadhwani. Chart displays recessions between 1972 and 2020. Provided for illustrative purposes only. Data as of March 2024.
Given their diversification characteristics, liquid alts have generally benefited investors through times when economic outcomes are unclear. Trend following and macro strategies have historically done well against a backdrop of recessions or high inflation, when compared with the 60/40 portfolio. For example, in 2022, a 60/40 portfolio was down more than 15%, while a trend following portfolio was up more than 15%.3 Liquid alts are adaptable as well. During rosier economic times, macro strategies are still likely to generate positive returns, making them conceivably a sound investment regardless of market conditions.
Rather than backing the investment styles, asset classes and investment vehicles that have performed well over the last decade, investors need to be cognizant that diversification comes in many different forms. While the endowment model has served them well, portfolios with a growing share of illiquid assets may be left more vulnerable to a situation where financial stress rises and liquidity once again earns a premia. This is why we believe it’s crucial to take a more holistic approach to asset allocation by seeking deeper diversification and uncovering hidden opportunities that can deliver in a changing world.
As market conditions unfold, where can agile investors unlock opportunities across the spectrum of public and private alternatives?
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