By HENRY H. MCVEY Oct 23, 2018

Low bond yields, a surge in geopolitical tensions, and a shift towards fiscal stimulus are all fueling a fundamental rethinking by the investment management industry of how to generate the best risk-adjusted returns. Against this backdrop, we have tried to articulate actionable solutions to many of the most complex investment questions that we are increasingly fielding from clients who – like us – use a rigorous, top-down approach to asset allocation. An important message, we believe, is that – amidst lower expected returns – the traditional relationship between stocks and bonds is now starting to mean revert after a 20-year hiatus. As such, we think that most multi-asset class portfolios likely need to be restructured to thrive in the new environment that we envision. Within the private markets, we remain constructive on the illiquidity premium, especially in Private Equity and Real Assets at this point in the cycle. Overall, though, as investors migrate towards more thoughtful multi-asset class portfolios to overcome the headwind of lower absolute returns, we think that there are some important ‘Rules of the Road’ to follow surrounding pacing, correlations, volatility, and liquidity, all of which matter to create successful outcomes for those who are currently rethinking their asset allocation.

There has certainly never been a dull moment in the macro and asset allocation business since I entered it in the early 2000s. What has changed in recent years, though, is that the complexity of mandates has taken an exponential step function upward. Record low bond yields amidst outsized intervention by the global central banking community as well as a surge in nationalist sentiment have fueled a rethinking of how to best generate strong risk-adjusted returns for pensions, endowments, foundations, sovereign wealth funds, and even individual investors. Without question, the growing complexity of the opportunity set has required a much deeper immersion into multi-asset class investing mandates. At KKR, we view this shift as a secular, not cyclical change, and as such, we have been increasingly addressing our clients’ requests by using a broader, more integrated tool kit than just our traditional macro and asset allocation work streams, including liability management, downside protection, hedging, and portfolio construction. Consistent with this initiative, we have also begun to work much more closely with accomplished CIOs to integrate and structure both liquid and illiquid mandates across a variety of investment disciplines, including insurance companies, run-off pension plans, and sovereign wealth funds.

Beyond the aforementioned strategic partnership and asset allocation mandates, we have completed two in-depth surveys on asset allocation strategies of the insurance and high net worth markets to better understand our clients’ needs and preferences within the Alternatives arena. In recent years we have also worked closely with KKR’s senior management to help better allocate the Firm’s own Balance Sheet, which now totals $17 billion in assets across all of the Firm’s major investment businesses, including Private Equity, Real Estate, Credit, Infrastructure, etc., on a global basis. Finally, we have become much more integrated with our Customized Portfolio Solutions team (CPS), which was formed by Saleena Goel in 2010 as a one-stop shop for those seeking a more thoughtful way to access a broader swath of private markets.

As one might expect, we are increasingly fielding an array of questions on market-related topics, including current macro trends, expected returns, illiquidity premiums, and portfolio construction. To be sure, we don’t have all the answers and we are constantly learning alongside our clients as well as evolving our business model. However, given the steady drumbeat of questions around a few of today’s ‘hot’ topics, we thought we might share our thoughts on several key areas where we think most global CIOs should likely have a strong view. They are as follows:

• Given lower expected returns, how does one think about a portfolio optimization process that leverages many of KKR’s top-down investment themes? Because of our forecast for lower returns, we think that portfolio optimization becomes even more important in the new environment we are envisioning for macro players and global asset allocators. Importantly, beyond a more thoughtful approach to asset allocation, we also believe that investing behind long-tailed investment themes that leverage both periodic dislocations as well as secular growth drivers will become an increasing source of alpha for CIOs who run multi-asset class portfolios that extend across regions. To this end, we detail below four long duration, macro-oriented investment themes that we believe can help investors generate significant outperformance during the next 5- to 10-years. Importantly, while each theme is different, there is a common thread amongst all of them: Buy Complexity and Sell Simplicity.
One’s destination is never a place but rather a new way of looking at things.

Henry Miller
American Writer

• Is Private Equity still an attractive asset class, particularly given the amount of capital that has now been raised in the sector? As our work below shows, we think that the underlying premise of Private Equity as a high returning asset class still holds true in absolute terms. Maybe more importantly, we think that Private Equity can handily outperform Public Equity at the asset class level in this part of the cycle. However, unlike many of the other asset classes in which our clients invest, manager selection in Private Equity is of paramount importance. So too is a thoughtful deployment schedule. Details below.
• How should we think about the illiquidity premium in Credit and Equity? What are the key drivers and is it still attractive in absolute and relative terms? See below for full details, but we identify several commonly watched macro factors that can help investors to better explain what drives the illiquidity premium across both Credit and Equity during different periods in the cycle. At the moment, our work shows that the illiquidity premium is appropriately priced (i.e., an investor is not overpaying for the return per unit of illiquidity). Interestingly, despite more capital coming into the alternatives arena, our research shows that illiquidity premiums have — thus far — remained fairly constant in recent years. However, as we detail below, there are parts of the alternatives market where we do have our concerns, including the lower end of the Direct Lending business. Our bigger picture conclusion, though, may be more important: given where absolute rates and relative credit spreads are trading in the liquid markets, the pick-up in return if a manager of illiquid assets can perform is as high as it has been since just after the GFC.
• How do you think about interest rates in a post-Quantitative Easing (QE) environment? This question is a tricky one, but we think the key relationship on which to focus is the relationship between nominal rates relative to nominal GDP. Also, the rate at which inflation is increasing is a key input. Our base case remains that, while nominal GDP is accelerating, we do not see upward inflationary pressures massively destabilizing the long-end of the curve. Key to our thinking is that some of the largest contributors to inflation, including rent and healthcare costs (Exhibits 57 and 58), are actually poised to plateau. As such, we see U.S. 10-year yields reaching 3.25% in 2018 and peaking at 3.50% in 2019. If we are wrong and rates do exceed our forecast, then we believe it will be linked to a combination of higher wages and a depreciating dollar.
• As one builds a more substantial private markets portfolio (in addition to a traditional liquid portfolio), what are the key portfolio construction metrics on which to focus? While there are many aspects of portfolio construction to consider, we focus on our top four for this note: pacing, correlations, proper comparisons for private market assets, and liquidity. There is no exact or ‘right’ way to approach these topics, but we strongly believe that there are tools that can be implemented to create better risk-adjusted outcomes, particularly as more and more CIOs increase their mix of private and public assets in their portfolios. One can also mitigate the negative effects of the J-curve in areas such as Private Equity through thoughtful implementation strategies, we believe. See below for details.

Looking at the big picture, our view is that we have entered a period of lower forward returns (See Exhibit 1, below). Indeed, given high margins and generally lofty multiples amidst low interest rates, more modest return forecasts certainly make sense to us. So, the real challenge is in implementing investment processes that minimize the downside – and unequivocally, we see the penalties for getting this wrong rising exponentially as QE comes to a close. We believe, for one, that there needs to be a greater emphasis on asset allocation than in the past rather than reliance on security and manager selection alone. Our visits with many CIOs, particularly in the pension, high net worth, and endowment communities, suggest that this shift is not as far along as it needs to be. Indeed, many plans are still only earning alpha from manager selection, not from asset allocation. We do not think this approach will be adequate in the new environment we are entering. Our world view also suggests that more allocators of capital should consider an investment in their global footprints – including a local presence in key markets – to better understand the profound impact that key considerations such as China, the millennial populations, and central bank policy are having on the macroeconomic and geopolitical landscape in each world region.

Section I

In this section below we specifically address in greater detail our response to the five questions that we most frequently field from our clients, global CIOs in particular.

Given lower expected returns, how does one think about a portfolio optimization process that leverages many of KKR’s top-down investment themes?

As any CIO who benchmarks his or her performance to a multi-asset class passive index knows, the traditional 60/40 portfolio has done exceedingly well in recent years. One can see this in Exhibits 3 and 4, which underscore that not only performance has been strong but also on a risk-adjusted basis, it has been even better.

However, as our expected returns assumptions indicate in Exhibit 1, the forward outlook could be quite a bit more muted, in our view. Indeed, assuming equity returns are roughly five percent over the next five years while bond returns are three percent, then a traditional 60% stock, 40% bond portfolio should only return about four percent in aggregate, which is well below most asset allocators’ return requirement of about seven percent. Even in a bull case scenario of 10% equity returns, high rates would result in zero percent bond returns, causing the portfolio to fall short of the seven percent target (Exhibit 6).

The other relationship that is changing, which we think could be a big deal for all macro and asset allocation professionals, is the correlation between stocks and bonds. To review, since the tech bubble peak in 2000, stocks and bond prices have been negatively correlated. As a result, weakness in the stock market has actually largely been offset with strong bond market performance amidst falling interest rates. One can see this in Exhibit 7. Not surprisingly, this macro backdrop has been a boon for multi-asset class investors, particularly levered ones such as Risk Parity.

However, this relationship is actually somewhat anomalous – an input that we think many current investors may be underappreciating. In fact, if you take a longer term perspective, the relationship between stocks and bonds since 2000 is actually an outlier, as stock and bond performance is traditionally positively correlated, not negatively correlated. So, in the event of a market dislocation in the future, we believe that many multi-asset class portfolios could endure much greater downside capture than in the past. The catalyst, we believe, will be the notable shift that we are now seeing amongst the global ‘Authorities’ away from monetary policy towards more fiscal policy (which likely means bigger deficits). As a result, bond prices will likely no longer rally in the event of an equity sell-off.

Consistent with this view, there is also the risk of much higher volatility ahead across the global capital markets. So, beyond the threat of lower absolute returns, our work also shows that the Sharpe ratio, or return per unit of risk, could be poised to fall. A mean reversion in Sharpe ratios would come as a significant jolt to many investors as return per unit of risk has been running well above trend line across most asset allocation accounts we monitor in recent years. We link the boost in return per unit of risk to the notable increase in coordinated global QE that started with the Federal Reserve and accelerated following the ECB’s commitment to do ‘whatever it takes’ in 2012. However, with QE shifting towards quantitative tightening (QT), we think that a secular shift in asset allocation is now upon us.

If we are correct in our macroeconomic forecasts, then all allocators of capital need to consider either lowering their liability payout amounts and/or shifting their allocations towards higher returning products. Just consider, if volatility remains constant from current levels, risk adjusted returns will fall a full 40% on average across asset classes as returns are expected to be lower across the board. This automatically results in lower Sharpe ratios, even before making any adjustments for potentially higher levels of volatility (which we think is inevitable). One can see this in Exhibits 11 and 12.

Against this backdrop, however, we do not expect allocators of capital to sit idle. Rather, we expect them to seek out pockets of alpha, align with the best managers, and cultivate relationships that allow them to drive better investment processes. To this end, we see at least four major macro themes that we believe that asset allocators, including both pensions and high net worth investors, can leverage to earn above average returns in the coming years as part of the asset allocation ‘refresh’ that we are advocating in this new era of investing.

First, we advocate a diversified portfolio that now benefits more from an improvement in nominal GDP. Without question, we believe that governments around the world are shifting their focus from monetary policy towards fiscal policy (Exhibit 13). This change is a big deal, in our view, and it requires a new approach to asset allocation. Given this viewpoint, we have materially increased our exposure to Asset-Based Finance. Indeed, as book values have again begun to grow in the banking sector, publicly traded financial intermediaries have finally started to ‘reposition’ their portfolios, including selling performing hard assets with onerous capital charges as well as seeking out capital relieving joint ventures with third party investors, including alternative asset managers. ‘Last mile’ residential construction in areas such as Spain and Ireland has been a particular focus of ours of late within Asset-Based Finance. We also view Asset-Based Finance as an elegant play on our desire to lock in low cost liabilities in today’s QE-driven market, allowing investors to earn above-average spreads. Finally, we are seeing an increased opportunity set in the B-piece segment of the commercial mortgage market, driven by ‘new’ retention rules that notably favor investors with long duration liabilities.

Meanwhile, within the Infrastructure sector, we have seen a notable number of divestitures of hard assets, particularly those with contractual revenue set-ups, in recent quarters. From our perch, it appears that Europe has emerged as the most active region for infrastructure carve-outs, but trend lines in both the United States and Asia are firming too. Importantly, this carve-out opportunity is in addition to some of the structural increases in infrastructure investment that we think will occur as governments rely more on fiscal spending than monetary stimulus to bolster growth in the years ahead.

Second, we continue to see a secular shift in capital formation away from traditional banks towards more Private Credit alternatives. Recall that before the GFC, banks and specialty finance companies and proprietary trading desks were the primary providers of debt capital globally. Now, with heightened regulation around leverage levels, global banks have constrained lending activity in many instances. Thus, we expect the demand for Private Credit from non-traditional capital providers to continue, particularly for financial sponsors that want speed and certainty around financings. Real estate credit in the U.S. (both B-piece and Stabilized Credit), bank disposition sales in Europe (both performing and non-performing), and performing Private Credit in Asia (Exhibit 19) all look interesting to us at the moment. As part of our normalization thesis, we also favor owning financial assets like mortgage servicing rights, which become even more valuable cash flow assets as rates increase (assuming unemployment does not spike during a downturn, which is our base view).

Third, we expect consumers to continue to shift towards more Experiences and away from more Goods. While this theme is not a new one for us, the pace of implementation appears to have accelerated in recent months. Importantly, we do not think the trend towards experiences is just the ‘Amazon’ effect. Rather, we believe that key influences such as increased healthcare spending, heightened rental costs, and rising telecommunications budgets (e.g., iPhones) are leaving less and less discretionary income for traditional items, particularly mainstream retail goods. One can see this in Exhibit 20. Recent trips to continental Europe as well as Asia lend support to our view that this trend towards experiences is global in nature and cuts across a variety of demographics. For example, in Japan and Germany, aging demographics are boosting the use of later stage healthcare offerings, while younger individuals in the U.S. are embracing more health, wellness and beautification. Our view is that mobile shopping and online payments are only accelerating this trend and our recent travels lead us to believe that this shift is occurring in both developed and developing countries. One can see this in Exhibit 23. Nowhere is this shift towards e-commerce more prevalent these days than in China (Exhibit 21) with its outsized millennial population (see China: A Trip to the Epicenter, August 2018). By way of background, of the total 828 million millennials in Asia, Frances Lim estimates that fully 40%, or 330 million, are today in China. To put the 330 million in perspective, we would note that there are ‘just’ 66 million millennials in the U.S.

Finally, we are structurally bullish on deconglomeratization. This theme is not new, but it is a powerful one that is accelerating the pace of corporate restructurings across the global capital markets. In our humble opinion, corporations used low-cost funding to over-expand in recent years, and with global trade now slowing at the same time domestic agendas are taking precedent, we expect more firms to hive off unprofitable subsidiaries and non-core businesses (Exhibit 25). This trend has fully gained momentum in Japan, Europe, and India, and we expect other business communities to move this way in the coming months and quarters.

We also note that we are seeing a lot of corporate ‘streamlining’ occurring outside of the traditional multinational sector. Indeed, after several quarters of inactivity, we are finally seeing U.S. energy companies rightsizing their footprints, as Wall Street encourages many of these companies to shed slower growth assets in favor of ‘hot’ shale basins. While this activity may not necessarily be long-term bullish for the stocks of publicly traded energy companies, it is creating significant, near term value-creation opportunities for the buyers of these properties, particularly for players with expertise in the production and midstream segments of the oil and gas markets.

Looking at the big picture, our bottom line for CIOs is that expected returns are now falling at a time when volatility is increasing. So, on a risk-adjusted basis, the next five years are likely to look dramatically different than the past five years. There are, however, important offsets to consider that can help to mitigate these challenging headwinds. First, we believe that asset allocators and macro investors can adjust their portfolios to better optimize their outcomes. One can see this in Exhibits 8, 9 and 10, respectively. Second, we believe that a much more theme based approach will be required to take advantage not only of secular themes but also periodic, tactical mispricings in the markets. As we described above, we are recommending four themes to capitalize on this approach. Finally, we think that, with operating margins high amidst low rates and full valuations, investors need to migrate towards buying some form of complexity (Exhibits 28 and 29) in a market where the consensus cherishes simplicity. In our view, this approach will help to minimize the adverse effects of the historic surge in financial asset prices that we have seen unfold since the end of the GFC in 2009.

What is our view on the Private Equity vs. Public Equity debate?

While we certainly field lots of questions about the forward-looking returns, one of the most frequent questions we get is actually not one about our views on absolute levels of return for each asset class in which KKR invests. Rather, it is about relative returns. In particular, we are most often asked whether Private Equity as an asset class will outperform Public Equities during the next five to seven years (i.e., the full life cycle of a private fund). Our simple answer is yes; we do think so, but we also want to caution that it is certainly not a ‘no brainer,’ particularly if you have a shorter time horizon. First, let’s start with where we have been. As we showed in Exhibit 1, Public Market Equities have actually outperformed Private Equity as an asset class handily over the past five years. Moreover, if one actually levers up the S&P 500 a turn or two from three to five times debt-to-EBITDA (i.e., more in line with a traditional buyout), then Public Equities have handily outperformed reported S&P 500 returns in recent years. One can see this in Exhibit 30.

So, given the recent underperformance, why would we be forecasting higher returns for Private Equity than Public Equities? For starters, our historical work suggests that Public Equities often excel early in the cycle, so we are not surprised in a turbo-charged, QE-driven bull market that Public Equities have outperformed (Exhibit 30). In our humble opinion, that is to be expected, given the starting level of stocks in 2009 as well as the $16 trillion that has been amassed on the balance sheets of global central banks in recent years. However, as public markets get more mature and more expensive during the later stages of the economic cycle, a more focused approach, particularly around value creation, sector selection, and target choice, usually makes more sense.

Second, as the industry has evolved, we think its comparative advantage has become more sustainable. In particular, we note that the Private Equity industry has substantially repositioned its skill set to focus more on operational expertise (relative to leverage), which tends to be more of a sustainable differentiator, particularly later in the economic cycle. One can see this in Exhibit 32. This point is a subtle but important one – one that we think sometimes is underappreciated by investors who have spent more of their time in public markets and may not fully recognize how much operational intensity goes into an investment during the typical five- to seven-year ‘holding’ period.

Another point to consider, one which we certainly see from our perch at KKR, is that Private Equity now covers a much broader definition than simply a traditional buyout. In our view, this flexibility of mandate in the Private Equity world should be a benefit at a time when it feels like many assets are being fully valued. In our Asia practice, for example, less than 50% of the deals are actually buyouts (Exhibit 34). In fact, a majority are linked to corporate carve-outs, de novo businesses, growth capital, etc. Also, in certain countries, Private Equity can provide a more thoughtful approach to sector exposure to key markets that may be either under- or over-indexed. In Indonesia, for example, the public markets actually have zero exposure to fast-growing sectors such as Technology (Exhibit 35). A similar story holds true in many Asian private credit markets as well. Meanwhile, in Europe, the Banking sector still accounts for 9.9% of the MSCI Europe index1, despite the reality that most private equity firms do very few bank-related deals (and the sector’s downbeat performance has been a material drag on overall public market performance).

We think that there are two other points to consider. First, we are not as bearish as some folks about the excess ‘dry powder’ in the industry. Key to our thinking is that dry powder is a function of available investment opportunities, and as one can see in Exhibit 37, the dry powder as a percentage of market capitalization is actually not much larger than it was a few years ago. This point of potential dollars to invest relative to the opportunity set is no different than the way we think about margin debt and merger and acquisition activity (i.e., both should also be looked at relative to market capitalization). Furthermore, unlike liquid market funds, dry powder tends to be deployed over a three- to five-year horizon.

Second, we believe manager selection matters (and can be a true absolute performance differentiator relative to Public Equities), particularly in Private Equity relative to many liquid alternatives. One can see this in Exhibit 39, which shows the difference between upper and lower quartile managers across a variety of asset classes.

At the high end of the dispersion analysis is where we find Private Equity, which makes sense, given the operational and strategic opportunities that we have highlighted earlier in this section as well as the ability to time entry and exits.

In sum, we think market timing between Private and Public Equities is largely a fool’s game, and as such, we continue to follow the long-term fundamentals, many of which suggest Private Equity remains a compelling asset class on both an absolute and relative basis. One can see the performance track record of PE on both an absolute and relative basis in Exhibit 40. Importantly, for larger allocators of capital who also invest in co-investments at a lower fee cost structure alongside their fund commitments, there is also the opportunity to reduce, or ‘buy down’, their overall cost per unit of PE capital deployed. That said, the industry is clearly changing, and we see competition intensifying even more. As such, for the Private Equity industry to earn its 500 basis points or more of illiquidity premium, it must continue to evolve towards being solution providers for corporations, which encompasses greater levels of industry expertise, operational acumen, and cross-border/consolidation capabilities, we believe.

Is the return premium in private markets still large enough to justify the illiquidity across Credit and Equities?

As members of the KKR GMAA team have had the opportunity to work more closely with CIOs on macro and asset allocation mandates, we have been able to delve more deeply into the merits and potential risks of using longer-duration capital to improve returns by tapping into the illiquidity premium. These efforts have been particularly relevant of late in key markets where global QE has made it extremely difficult for managers to deliver on their liability payout assumptions. Not surprisingly, though, we have found that the most adept users of illiquid assets, including thoughtful insurance companies and pensions, generally follow a disciplined pacing program, and they implement a diverse, appropriately sized co-investments program to manage J-curve considerations. They also place a huge emphasis on liquidity considerations, so that they are never forced sellers.

So, if we agree that those are some of the potential guiding principles to which we should all adhere, then another key part of the debate about investing in Alternatives is whether the absolute level of the illiquidity premium makes sense for the risks being taken. There is no ‘right’ answer to this question we believe, but my colleague Frances Lim and I decided to dig deeper into this topic by looking at the illiquidity premium for both the private equity and private credit markets.

Historically, our work shows that illiquid investments have performed better than liquid market investments. We think this is true for a number of reasons. First, investments in the private markets are not passive investments. They are bought and actively managed as owners and operators in many instances. As we mentioned earlier, the importance of operational improvement has grown steadily over time (Exhibit 32). Second, illiquid markets, by definition, are not as efficient. They also provide an embedded option on when to buy and when to sell, which we think is quite valuable relative to the traditional liquid markets. Third, there is often much better alignment between management, investors and shareholders. For example, in today’s environment, the ability to have a long-term view and execute on that vision to create value, regardless of the short term fluctuations in the markets, is a competitive advantage, we believe. One only has to look at why more and more companies in the U.S. Technology sector are staying private in today’s environment.

So how do we do think about the illiquidity premium across asset classes? On the equity side, for example, our view is that the average outperformance of global Private Equity relative to the MSCI All Country World Index (ACWI) typically hovers, around 400-500 basis points. One can see this in Exhibit 42. As one might expect, the outperformance does not occur every year. In fact, we estimate that during the past 30 years, there have been 10 years when Private Equity underperformed Public Equities, with the average underperformance totaling 820 basis points — not an insignificant number for about one third of the time.

Interestingly, though, as we show in Exhibit 43, the periods when the liquid markets did better than Private Equity typically occurred in years with exceptionally strong public market performance. All told, during these 10 years when Private Equity ‘underperformed’ liquid markets, the average return for Private Equity was a full 16.1%, compared to a sizeable 24.3% for Public Equities during the same period (and 10% for U.S. Public Equities on a long-term basis).

So, what macro factors influence the long-term performance of Private Equity over Public Equities? Our work shows that the long-term ‘overage’, or outperformance of Private Equity relative to the MSCI ACWI, is – as one might expect – positively correlated to growth factors like real GDP, equity market performance, and credit spreads. The overage is also positively correlated with interest rates. Higher rates normally reflect both a strong growth environment and more demanding funding environment, which often leads to multiple contraction. One can see the variety of influences as well as their betas in Exhibit 44.

My colleague Frances Lim then took the analysis a level deeper and looked for direct explanatory variables where we could create some predictive capability. She identified five factors, including U.S. real GDP growth, the U.S. Fed Funds rate, corporate BBB yields, the U.S. nominal trade weighted index, and the VIX volatility index, that help to explain about 80% of the illiquidity premium for Private Equity, we believe. One can see this in Exhibit 45. As one might expect, however, the overage of PE performance relative to Public Equity performance tends to be negative coming out of a recession. This fact pattern makes sense to us given significant multiple expansion that Public Equities enjoy early in the cycle as well as the relative value creation via operational improvements by Private Equity later in the cycle.

On the Credit side, many of the patterns we identified in Private Equity relative to Public Equities also hold true, though the absolute premium is smaller. Specifically, according to our work, Private Credit generally outperforms the liquid high yield market by about 200-300 basis points throughout the cycle, compared to 500 basis points or so for Private Equity relative to Public Equities. One can see this in Exhibit 46.

However, similar to Private Equity relative to Public Equities, the outperformance is not always consistent. In fact, there are significant periods of underperformance for Private Credit relative to Liquid Credit (Exhibit 47). As one might expect, the periods of lagging performance are generally linked to strong capital markets performance, including liquid credit securities.

Maybe more importantly, Frances spent time understanding the drivers of the variance in the Credit illiquidity premium. The macro factors impacting the Credit illiquidity premium were actually quite different than those identified for Private Equity. While U.S. real GDP growth remained a common factor for forecasting the overage amount and the absolute level of the illiquidity premium in both Private Credit and Private Equity, the other macro drivers were different for Private Credit. Specifically, instead of using the Fed Funds rate, the BBB yield, the VIX volatility index, and the U.S. trade weighted dollar (all four of which were used in our PE illiquidity premium model), our forecasting model for the illiquidity premium in Private Credit uses the 10-year Treasury yield, the performance of the S&P 500, U.S. CPI, and the U.S. deficit. All told, these five factors can explain 71% of the variation in the illiquidity premium.

Not surprisingly, the correlation of the spread between Private Credit performance and Liquid High Yield performance against macro factors is actually quite similar to that of Equities both in terms of direction and magnitude. Specifically, the Credit illiquidity premium is positively correlated to growth factors and negatively correlated with the unemployment rate, current account balance, and economic uncertainty. One can see this in Exhibit 48.

Importantly, though, where Private Credit and Public Equities illiquidity premiums differ is in the magnitude of their betas as the Credit illiquidity premium is lower than the Equity illiquidity premium. We attribute this to Private Credit’s position in the capital structure, which is senior to Public Equities. We also believe the beta against macro factors is lower due to the nature of underwriting where both upside and downside are more limited for Private Credit relative to Public Equities as credit underwriting is typically focused on the fixed income stream and preservation of committed capital versus more of the absolute upside in Public Equities.

So, what is our bottom line? Our work confirms the thesis that private market asset classes tend to perform better as mid-to-late cycle asset classes, which helps to boost their overall performance statistics relative to liquid markets over the life of a fund (which we view as the relevant time period). This relationship makes sense to us, given the valuation recovery liquid markets enjoy early in a cycle as well as the benefits that operational improvement provides private markets later in a cycle. The illiquidity premium is also more valuable in a low rate environment, we believe, because its contribution to the overall total return increases as expected returns decline. We also take some comfort in the fact that the illiquidity premium across both Private Credit and Public Equities does not seem to be shrinking materially, despite the continued maturity of both asset classes. Also, as we showed earlier, dry powder relative to market capitalization is actually in line with historical norms.

If interest rates are the key to valuation across most asset classes, what is your framework for forecasting the direction of interest rates?

As one might expect, we think getting interest rates right is one of the most important drivers of outperformance in the macro and asset allocation arena. Key to our thinking is that government bond yields form the base for price discovery in almost all other fixed income asset classes, and as such, they shape how and where investors allocate capital across the global fixed income universe, in both liquid and illiquid markets. Interest rates also impact cap rates and drive equity multiples. So, if there is one question investors need to get right at a time when quantitative easing is transitioning towards quantitative tightening, then we think it is linked to the direction of U.S. interest rates.

At its core, we view interest rate policy as being inherently linked to nominal GDP growth. One can see the tightness of the relationship in both Exhibits 52 and 53. So, to get interest rates right, one needs to get nominal GDP right, and to get nominal GDP right, you have to have a view on U.S. real GDP growth and U.S. inflation.

Importantly, though, while U.S. interest rates and U.S. nominal GDP growth are highly correlated, the relationship is not static over time. Exhibit 53 illustrates the different regimes of yields relative to nominal GDP that have existed since the 1950s. While regimes have varied, what we think stands out is that in the U.S., interest rates have tended to run moderately below the level of nominal GDP growth as long as the Fed was not actively trying to suppress run-away inflation. It was only during the Chairman Paul Volcker Fed era of the 1980s that rates ran notably above nominal GDP for a sustained period. Put in a more simplistic way, we view Fed policy and corresponding interest rates as a function of nominal GDP growth. When growth is too weak, then interest rates are held below nominal GDP to accelerate growth. When growth and inflation are strong, interest rates are often held above nominal GDP growth.

Looking ahead, our belief is that inflation will move up but not run away to the upside (i.e., we will not have a prolonged, upward surge in inflation, which is what materially dents bond yields). Key to our thinking is that the Phillips Curve is not as steep as it used to be, in our view. Employers generally have pricing power/negotiating power, though we do acknowledge that cyclical pressure on wages is likely; importantly, we agree with the Federal Reserve that the participation rate has a little more wiggle room to increase.

In terms of the technical definition of the Consumer Price Index, my colleague Dave McNellis has been right to point out that the official measures include a notable combination of idiosyncratic inputs (e.g., home rental prices) as well as some regulated inputs such as healthcare costs.

As we show in Exhibits 57 and 58, both appear to be leveling off. So, we do not expect a sustained, near-term surprise spike in inflation reports, even if wages do increase from current levels. We also believe that U.S. real GDP will not materially overshoot on the upside, as our research continues to show that GDP will be restrained by challenging demographics and pockets of global excess capacity. Finally, with the recent surge in the U.S. dollar, our more cyclical indicators suggest the risk of a surprise bout of inflation remains minimal. As such, our base case is that rates can run in a range of approximately zero to 1.5% below the rate of nominal U.S. GDP growth.

Beyond the fundamentals, we also think the technical influences matter a lot. Importantly, as we show in Exhibits 63 and 64, we are entering a major inflection point in terms of supply-demand balance by the Federal Reserve and European Central Bank. That’s the bad news, and it is likely to lead to some increase in the term premium in U.S. fixed income.

The good news is that we do not believe that the Fed will move quickly to sell off securities, while our conversations with central banks outside of the U.S. continue to support a very dovish outlook for global rates. This viewpoint is significant as global fixed income managers believe strongly that there is attractive relative value in U.S. Treasuries. One can see that in Exhibit 67. Moreover, we are close followers of Dallas Fed governor Robert Kaplan, and agree with his thesis that demographics, excess capacity in China, and rapid technological change are all likely to keep long-term rates structurally lower than traditional economic models might suggest2.

So, to summarize, our base case is that interest rates should head higher over the next few years, but not in the uncontrolled fashion that some investors now think. Key to our thinking is that inflation does not materially surprise to the upside, and as such, the long-standing relationship between nominal GDP and nominal interest rates holds. Under this scenario, we think that equity multiples will have peaked and sovereign bonds no longer perform their traditional roles as income producer and shock absorber in their portfolios. However, as we indicated in Exhibit 1, we still think that long-term government bonds can produce a positive nominal return for investors, albeit one that is meaningfully lower than in the past 5- and 10-year periods, respectively.

How should one think about measuring return, risk, and liquidity in a portfolio that incorporates illiquid assets into the mix?

As we have built out the Global Macro & Asset Allocation, Risk, and Balance Sheet team at KKR, we have drawn on a variety of resources from across the investment management industry in formulating the right mix of liquid and illiquid assets in a portfolio. In particular, we have levered many of the best practices from the liquid markets to help portfolio managers within our private markets operations at KKR build sound and durable portfolios across our business units. We have also implemented many of these same techniques in our strategic partnership business, as CIOs are demanding innovative ways to deliver returns via differentiated opportunities across both public and private markets. Thus, while we typically lean primarily into illiquid asset classes for their attractive illiquidity premia, we do also make tactical allocations to more liquid asset classes, (such as Liquid Credit, Liquid Equities, Total Return Swaps, etc.) with the ultimate goal of building integrated portfolios that are balanced and can perform well through various market environments and economic cycles.

Although portfolio managers and CIOs who run these programs need flexibility to adjust their asset allocation and time to allow their convictions to play out, consensus around use of non-traditional strategies to try and earn outsized, idiosyncratic returns has grown notably in recent years since our arrival at KKR. This was apparent in our 2018 Insurance Asset Management Survey where more than half of the CIOs with whom we spoke – a group that we think collectively represents over 40% of total insurance assets – intends to increase their allocations to Private Equity and Private Credit during the next 12 months. Notably, more than one-third of these CIOs were planning to fund these increases primarily from cash reserves and Public Equities to enhance income-based returns. In addition, nearly 30% were planning to raise their allocations to Private Equity as returns are attractive enough to offset increased capital charges associated with equities.

Looking back over time, however, really provides some perspective on the growing use of Alternatives, particularly in the endowment community. In 1985, for example, over four-fifths of the Yale Endowment was committed to U.S. stocks, bonds, and cash. Today, public domestic securities account for approximately one-tenth of the portfolio, while foreign equity, private equity, absolute return strategies, and real assets represent nearly nine-tenths of the Endowment3.

In our experience working with clients that are expanding into Alternatives, we have developed a few ‘Rules of the Road’ that would make sense for CIOs to ask of their managers as well as of themselves. First, somewhat similar to marriage, investing into Alternatives is not a decision that is to be taken lightly. All kidding aside, understanding what you are buying as well as using a measured, diversified approach to legging into Alternatives are critical variables. So, too, is the entry mechanism. In fact, after studying many decades of KKR’s fund performance as well as some of the quantitative work KKR has done around deployment patterns in Saleena Goel’s CPS team, we found that fund managers that maintained discipline around pacing outperformed. This point may be a subtle one, but it is an important one. Not surprisingly, a similar story holds true for clients that built a steady game plan for increasing exposure, versus making a concentrated bet around vintage risks. Given that the U.S. stock market is now amidst the longest bull market in history, the importance of this insight cannot be overstated, in our view.

Second, understanding correlations within a fund and across funds (both liquid and illiquid) is extremely important. Most portfolio managers track correlations of individual positions across liquid market asset classes. Importantly, though, these correlations are not static, and in some cases can change and even invert.

As a result, it is critical to continually update one’s perspective on the underlying positions in a single fund, or even the compilation of different funds and their underlying positions. Investing in a private market asset class should not be any different, in our view, and as such, we incorporate this reality into all of our private side risk analytics.

Maybe more important, though, is that — as asset allocators compile portfolios that transverse both liquid and illiquid portfolios – they have an integrated system that allows them to understand how the aggregate portfolio will perform. From what we can tell, many investors tend to focus either on the liquid portfolios or the illiquid portfolios in isolation. We think that the opportunity is to integrate these systems into one seamless analytical dashboard for risk management, and as such, it is a high priority for us when we are working with clients on better understanding the underlying traits of their overall plans.

Importantly, as returns across asset classes have fallen, the dispersion of expected returns across asset classes has narrowed. This reality has encouraged us to put even more emphasis on sizing the various opportunity sets we evaluate. As a result, we are increasingly working harder to build portfolios of funds and co-investments that are not overly concentrated to one macro factor, theme, or capital markets assumption. Said differently, just analyzing traditional sector allocations is not adequate for gauging the underlying risk of one’s portfolios. We also aim to assess forward-looking factors that should be considered, not just historical ones that now may be less relevant. So, when we run multi-asset portfolio optimizations at KKR, we typically seek to maximize the expected return per unit of risk of our allocations based on both historical return and target return scenarios under various constraints (e.g., expected risk/return profile of allocation desired by investor, target cash yields, volatility constraints, liability profile, etc.)

Third, we acknowledge that there is a significant lag in obtaining performance statistics for private market portfolios. Unlike listed and traded securities, the lag is generally between six- to-eight weeks after the quarter end, and on a quarterly basis at best. As a result, as the private market portfolio grows, an asset allocator must use proxies to understand exposures and risks holistically across the entire portfolio, including both private and public positions. As one might suspect, there is no perfect way to perform this exercise, and we fall back on our expected return framework for estimating returns. Ultimately, private market returns are a function of their liquid market counterparts with an illiquidity premium. Thus, using this framework, portfolio construction across liquid and illiquid markets is not too dissimilar.

For the private markets performance index proxy approach, there are various indexes one can use to calculate alternative investment performance, such as Cambridge Associates, Preqin, etc. For the public markets proxy approach, we typically suggest using as proxies portfolios of comparable public companies. At KKR, we spend a significant amount of time identifying the public companies that are most likely to capture as closely as possible the macro risk factor exposures of our portfolio companies and we typically leverage-adjust these public marks to account for the differences in leverage between our portfolio companies and comparable public companies.

There are pros and cons to both approaches:

• Using private markets performance indexes will better capture the actual volatility an asset allocator will see in her/his portfolio in most market environments, but can sometimes understate the intrinsic correlations with traditional asset classes. Private markets indexes are also lagged and often restated. Furthermore, benchmarks often reflect more seasoned portfolios, which can sometimes be misleading.
• Using public market proxies can do a slightly better job of capturing the intrinsic correlations with other asset classes, but will overestimate the actual volatility in marks an investor will experience in her/his portfolio. Although liquid market data is real time, CIOs and CROs must constantly remind themselves that the data is not actual, and as such, proxies can diverge meaningfully from the underlying actual private investments. There are also instances where appropriate liquid market comparables are not available, such as in the Indonesia technology example cited above in Exhibit 35.

Our bottom line: What the right proxy should be really depends on the use case. In most instances at KKR, we typically use private markets proxies for asset allocation decisions for multi-asset portfolios, but we will use public markets proxies for fund-level portfolio construction decisions, particularly as we think about the pro-forma impact of potential new deals on the risk profile of a fund and cross-portfolio correlations.

Maintaining ample liquidity as well as funding considerations when one is ramping a private market program are also important inputs to our ‘Rules of the Road’ framework. Simply stated, the key is to build a robust private markets investment program where cash drags and upfront capital calls do not destabilize the existing plan. Of late, we have spent an increasing amount of time with insurance firms and other publicly traded entities in financial services working on innovative ways to create exposure in private markets without being over-concentrated or taking vintage risks – and not have idle cash dent returns. Thoughtful portfolio construction of PE fund types as well as innovative transition management programs can clearly help boost returns, but other techniques, including the use of co-investments and other seasoned assets, can help too. As a result, Saleena Goel and our CPS team have been able to create private market programs that have clients out of their J-curve headwinds within 6-18 months, in many instances.

In summary, our message is that, while private market investing can produce attractive returns, there are many potential pitfalls along the way. At a minimum, pacing matters at both the fund and asset class level. Understanding correlations not only across private funds but also the relationships between all funds in a portfolio, including both public and private ones, is increasingly important, as allocators of capital try to form holistic views of their risk profiles. Measuring performance to get an accurate snapshot of current valuation marks can also be complicated, and as such, it requires a more thoughtful approach. Selecting the right entry mechanism/partner is paramount as well. Overall, as we have detailed above, we have migrated towards an integrated approach to portfolio construction that harnesses what we believe are the best attributes of both private and public markets.

Section II: Conclusion

Without question, the current period is one of the most complicated times that we can remember as top-down, macro investors, and as such, we are not surprised that the steady drumbeat of questions around what it all means for portfolios has increased materially in recent quarters. To this end, we have tried to use this article to address many of the most frequent questions that we hear from clients who use a rigorous, top-down approach to asset allocation.

To be sure, we have not covered all the topics that we have researched of late (or those that we would like to address), but we do have high conviction that:

• Given our strong belief that forward returns are likely to be much lower, we think that portfolios need to be properly restructured for the new environment that we envision, and it likely involves owning more alternative assets and less government bonds. This viewpoint is particularly relevant to allocators that have annual fixed payout schedules, including many pensions and endowments. Also, as we describe in detail in this article, we believe strongly that there are several top-down macro themes that can – if implemented properly – add significant alpha to one’s portfolio.
• Private Equity will likely outperform Public Equities at this point in the cycle. Without question, we believe that operational improvement will become of paramount importance, as quantitative easing (QE) transitions towards quantitative tightening (QT). Maybe more important, though, is that almost more than with any other asset class (except maybe Venture Capital and Natural Resources), manager selection is also critical to not only driving outsized returns in Private Equity but to also limiting downside risks, including impairment of capital.
• In today’s low rate environment we remain quite constructive on the illiquidity premium and what it means for overall returns if this premium is harnessed properly. In particular, the value of a 200-500 basis point illiquidity premium — in a world where the absolute return for stocks and bonds is less than six percent and four percent, respectively — is as high as it has been in decades, we believe.
• We do think long-term rates are headed higher in the near term, but we do not think that they will increase in an unmanageable way. From an asset allocation standpoint, we are underweight duration, and we favor as much upfront yield as one can find in a thoughtful risk-adjusted manner. Consistent with this view, Real Assets is a notable overweight in our target asset allocation.
• As investors increase their allocations towards some combination of public and private investments, we think that there is an important set of ‘Rules of the Road’ that must be followed. Pacing, correlations, volatility, and liquidity all matter to ensure a smooth transition.

While we feel confident about the frameworks that we have laid out for investors, our final point is that flexibility remains of paramount importance. Geopolitical tensions, including heightened trade disputes, are not likely to abate soon. At the core of these debates are important questions about income inequality and global supply chains. Also, technological innovation is changing traditional business models at an unprecedented rate – one that is likely to lead to a greater bifurcation between winners and losers in the global economy than in the past. Given these macroeconomic and geopolitical crosswinds, we think that investors must continue to adjust their approach to leverage not only the macro and asset allocation tools that have worked in the past but also incorporate new tools that are currently being developed, particularly in areas such as portfolio construction, new product innovation, and data analytics.

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