Regime Change: The Role of Private Equity in the ‘Traditional’ Portfolio

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At KKR we still firmly believe that we have entered a different macroeconomic regime for investing, where the traditional relationship between stocks and bonds has changed. Against this backdrop, we think that new approaches to asset allocation should be considered. So, in our newest piece on portfolio construction, we focus on the role Private Equity can play in a diversified portfolio, and as part of this exercise, we look at the potential trade-offs different investors may want to consider as they think about optimizing returns across a variety of economic environments. Our punch line is that Private Equity, similar to Private Credit and Real Assets, can be quite additive to traditional investment portfolios, especially for investors who are concerned about inflation and/or do not face meaningful near-term liquidity constraints.

Habit is a great deadener.
Samuel Beckett Irish novelist, dramatist, short story writer, theatre director, poet, and literary translator

For quite some time we have been arguing that we were entering a new macroeconomic regime, driven largely by non-traditional supply shocks, including a labor shortage, rising geopolitical tensions and realignments, and the global energy transition. Building on this viewpoint, we began publishing a series of notes on portfolio construction (see our Regime Change series focusing on Alternatives and a deep dive into Private Credit) using the 60/40 stock-bond portfolio as the point of reference, and we have proposed – given this new environment – that investors consider pursuing two main objectives aimed at improving their asset allocation. They are, in order of importance:

  1. Increasing inflation protection by adding more Real Assets, given our house view that there will be a higher resting rate for inflation this cycle; and
  2. Improving the robustness of a diversified portfolio by adding private Alternatives, including more floating rate private debt (e.g., Private Credit) and Real Assets, based on our belief that the established relationship between stocks and bonds that exists in a traditional 60/40 portfolio has now changed (Exhibit 1).

To achieve these objectives, we proposed investors consider modifying their traditional 60/40 allocation into a stylized 40/30/30 portfolio where the 30% allocation in Alternatives would be distributed equally between Private Credit, Real Estate and Infrastructure (Exhibit 3). Our research shows that unless one believes that we are returning to a low growth, low inflation environment (i.e., the bottom left quadrant of Exhibit 2), our 40/30/30 portfolio has the potential to not only deliver better returns but also reduce risk across most macroeconomic environments (see Exhibit 4).

Importantly though, one asset class that we have not discussed thus far is Private Equity. We have been asked the question many times now by our clients “Where is Private Equity in the 40/30/30 portfolio?” To date, given our intense focus on the implications of higher inflation on bond prices, we have generally answered by pointing to our call for investors to first address the two priorities listed prior, before entering the Equity (public or private) discussion. That said, with our previous publications on the 40/30/30 allocation focusing on Real Assets and Private Credit now done, we are using this note to discuss how one might consider allocating to Private Equity within a diversified portfolio.

So, what is our punchline on Private Equity allocations? As we detail below, we remain quite bullish on the asset class. As one might guess, however, any discussion on the addition of Private Equity to one’s portfolio does include some trade-offs. Within the traditional institutional segment of our client business (where there is often less emphasis on near-term liquidity), for example, CIOs have increasingly replaced a significant portion of their Public Equities allocation with Private Equity to take advantage of the stronger returns the ‘illiquidity premium’ 1 provides to Private Equity. One can see an example of our suggested Institutional style target portfolio in Exhibit 3, where Private Equity represents one third of the overall Equity sleeve. Consistent with this approach, this portfolio caters to allocators who are willing to give up some liquidity for potentially higher longer-term returns 2. Indeed, in the Institutional style portfolio, the Private Equity allocation is in addition to – not in lieu of – the other 30% of Alternatives, including Private Credit, Real Estate, and Infrastructure, that we have been discussing within our original 40/30/30 construct. Said differently, Private Equity replaces some of the Public Equities allocation, not other parts of the Alternatives mix.



The Positive Correlation Between Stocks and Bonds Has Continued to Stay Elevated, a Key Feature of Our New Regime Thesis

Graph of the Positive Correlation Between Stocks and Bonds
60-40 Portfolio modeled using S&P 500 and Barclays U.S. Aggregate total returns, assuming weekly rebalancing. Data as at December 31, 2022. Source: Bloomberg, KKR Portfolio Construction analysis.


While 2023 Should Be a Lower Inflation Environment, We Believe a Regime Change Has Occurred

Graphic of Inflation and Growth Regimes over time
Data as at November 30, 2022. Source: KKR Global Macro & Asset Allocation analysis.

We recognize that a 45% allocation to Alternatives (i.e., the Institutional style portfolio), which is the level many more established endowments, family offices, and pensions are targeting in their asset allocation frameworks, might feel too lofty for those who place a higher premium on liquidity. As such, we decided to think about a total allocation towards Alternatives of 30%, including Private Credit, Real Assets, and Private Equity. One can see this more Private Wealth style portfolio, which includes an Alternatives bucket of 10% Private Equity, 5% Real Estate, 5% Infrastructure, and 10% Private Credit, in Exhibit 3. To be sure, not everyone is going to want 30% in Alternatives; but for the cohort that does, there are lots of variations that one could consider. Our goal, among others, in this note is to create a basic framework allowing all investors to begin to bet- ter appreciate some of the trade-offs between return, liquidity, risk, and inflation protection that various asset classes provide, while emphasizing Private Equity.



The Addition of Private Equity Can Boost Portfolio Returns Across a Variety of Portfolios

Bar Chart Showing Traditional and Enhanced Portfolios
Data as at February 17, 2023. Source: KKR Portfolio Construction analysis.

When Allocating to Alternatives, One Needs to Think Through the Benefits of What Different Strategies Can Provide

Benefits by Asset Class
Why Now?
Private Equity generally outperforms Public Equities in almost all environments except the ‘low inflation/low growth’ regime. In high inflation periods, for example, PE has generated returns in excess of about 6% above public stocks. Interestingly, Private Equity’s excess returns are actually greatest when Public Equities deliver low returns.We think returns for most all asset classes will be much lower going forward, an environment that has often enabled Private Equity to outperform relative to Public Equities. Importantly, in all the regimes we studied over several decades, PE has on average empirically delivered excess returns of about 4.3% on a net annualized basis, though as we detail below, relative performance has tended to be best in choppier markets. This relationship of outperformance also holds true across regions.
Infrastructure and Real Estate assets often have inflation indexation embedded in their cash flows; the replacement value of their assets also increases in a rising nominal GDP environment.Given that we see a higher resting heart rate for inflation, we believe investors should protect purchasing power by diversifying their portfolios to include more Real Assets linked to nominal GDP. Pricing escalators embedded in contracts as well as assets linked to GDP growth tend to outperform in environments where inflation is above a central bank’s target.
Private Credit can improve the return and risk profile of a traditional portfolio, as its floating rate feature helps boost the income-generating component of the fixed income allocation in a rising rate environment. It can also act as a portfolio diversifier and can shorten duration in many instances.With banks pulling back from lending these days, there is a significant opportunity for Private Credit to earn attractive returns, even on an unlevered basis. Moreover, both companies and financial sponsors tend to use Private Credit solutions more in a backdrop of tightening financial conditions, which is clearly the environment we are now in.


Based on Historic Returns, the Addition of Private Equity to Portfolios Can Often Help Achieve Better Risk- Adjusted Performance

Table Showing How the Addition of Private Equity Can Impact Performance
Portfolio returns and volatility modeled using annual total returns from 1928 to 2021 for the S&P 500, from 1978 to 2021 for Real Estate, from 2004 to 2021 for Infrastructure, from 1928 to 2021 for Bonds, from 1981 to 2021 for Private Equity, and from 1987 to 2021 for Private Credit. Assumes continuous rebalancing of the portfolios. U.S. equities modeled using the S&P 500 Index. Bonds modeled using a mix of 50% U.S. T-Bonds and 50% Baa Corp. Bond annual returns, computed historically by Aswath Damodaran (NYU Stern). Real Estate modeled using the NCREIF Property Levered Index. Private Infrastructure modeled using the Burgiss Infrastructure Index. Private Equity modeled using Burgiss North America Buyout Index. Private Credit modeled using the Burgiss Private Credit All Index. Cash yields modeled using annual data from 2000-2021 for all asset class with exception of private real estate (2005-2021), Public Equity using S&P 500 12M gross dividend yield, Private Equity proxied using S&P Small Cap 12M gross dividend yield, Private Infra proxied using S&P Infrastructure 12M gross dividend yield from 2006 onwards and 2000-2006 back filled using S&P Utilities, Public Credit based on Bloomberg Aggregated Credit yield to worst, Private Credit using Cliffwater Direct Lending Index Income Return, Private Real Estate based on NCREIF NPI cap rate, Source: Burgiss, Aswath Damodaran, Bloomberg, NCREIF, KKR Portfolio Construction analysis.

So, what is the punch line for an allocator who adds Private Equity to the mix of Alternatives and how might this compare to the traditional 60/40?

  1. We use the term ’illiquidity premium‘ broadly, with no suggestion that it is simply a passive risk premium or beta factor. Indeed, based on our broad definition, ’Company Value Creation‘ through operational improvements, which is clearly idiosyncratic alpha, also qualifies as a component of the ‘illiquidity premium’, as well as leverage, deployment pacing, monetization timing, and sector allocation.
  2. Note that many ultra-high net worth investors are focused on creating intergenerational wealth and have less liquidity constraints as well. These types of investors typically adopt an institutional or endowment style model heavily weighted towards Alternatives. There are also tax benefits for longer term investing that we will discuss in a future paper.