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The illiquidity tradeoff - Why private markets are worth locking up capital for longer

It is natural for investors to want constant access to their capital. This extends well beyond a simple bank account. Everything from blue chip stocks, government bonds, and exchange-traded funds can be sold at great speed. In times of heightened economic uncertainty, this desire to be nimble can be particularly strong.

So why might investors be willing to tie their capital up for sometimes long periods of time in private investments? In this article, I’ll discuss some of the reasons why private markets can be worth the trade-off for those who are willing and able to sacrifice liquidity.

 

Antoinette Zuidweg
Alternative investments strategist, UBS Chief Investment Office

 

A starting point is that liquidity itself can be a double-edged sword—it enables investors to adapt swiftly to market shifts but can also contribute to making rash decisions. Locking up capital for longer can prevent investors from making emotional decisions that damage returns.

A more critical consideration is that investors have historically been rewarded for the patience required in allocating to private markets. From 2001 to 2022, the Cambridge Associates private equity index shows annual returns of 13.1% for the segment—versus 5.8% for the MSCI AC World Index. We have also noted that putting fresh capital to work in private assets in the years following declines in public markets has historically proven to be a rewarding strategy over the long term. Using Cambridge Associate data, we see the average vintage year internal rate of return increases from 8.0% two years before market peak to 19% one year after market peak.[1]

Meanwhile, much of the action has been shifting away from public stock exchanges, as more innovative companies stay private for longer. The number of publicly traded companies in the US has dropped by more than 50% since the 1990s, according to data from the Center for Research in Security Prices. Private markets can therefore offer investors access to opportunities not available on public exchanges.

We caution, however, that trying to time private equity investments often leads to suboptimal results. Instead, we believe it is best to focus on a consistent deployment plan in line with an investor’s long-term goals. In our view, many investors—depending on their liquidity restrictions, personal circumstances, goals, and risk tolerance—could benefit from an allocation of up to 20% to less liquid assets in their portfolios. When investing indirectly in private markets via funds, the key to success lies in the selection of and gaining access to the right fund manager.

 

Where are the best private market opportunities today?

In private equity, dispersion across valuations offer interesting entry points. Managers who can spot value could take advantage of the current environment to acquire assets at compelling valuations. As companies streamline costs and focus on raising liquidity, activity has increased for add-on deals, carve outs, and divestitures. To take advantage of these opportunities, we prefer exposure to value-oriented buyout strategies. Private equity can also provide investors with more direct access to opportunities in secular trends that are unlikely to abate even in a lower economic growth environment—from the transition to the green economy to growing healthcare needs, the digitalization boom, or artificial intelligence.

In private credit, direct lenders have become a critical source of funding, especially for small and mid-sized companies. This is a trend we expect to continue. Compared to other fixed income strategies, private loan investors benefit from a senior position on the capital structure as well as from floating rates, a high level of control, and lower volatility. Current market dynamics are providing structural support to the asset class. With tighter financing conditions and higher interest rates, direct lending managers are able to negotiate better spreads, lower leverage, and stronger covenants. Yields on newly originated loans in the first half of 2023 stood at about 12.5% per year, based on JP Morgan data. But we do expect some credit deterioration going forward. Default rates have started to pick up and could rise to the mid-single digits in 2023. While this could trigger some losses, total returns should remain positive in the mid-single digit range, driven by high income generation.

For real assets, we recommend selectivity in the real estate market amid potential headwinds for US commercial properties on the back of tightening financing conditions. We still expect investments in logistics, healthcare/medical centers, self-storage and data centers, and telecommunication towers to fare better. We are selective on the residential market depending on the location and the specific demand/supply balance. Meanwhile, infrastructure-linked assets have generally showed more resilience to macroeconomic pressures and benefit from policy and structural tailwinds. Not all infrastructure assets are created equally, however. And in the current environment, we recommend investing in core assets that are less exposed to cyclical pressures, that can rapidly adjust revenues to inflation, and that benefit from strong government support.

 

Keeping an eye on long-term risks

When investing in private assets, it is important to remain aware of the risks related to the asset class. These include illiquidity, longer lock up periods, lack of control and transparency, leverage, fees, and concentration risks. These risks can be partially addressed through thorough due diligence, strict manager selection, and diversification across strategies, vintage years, and geographies.

 

 

Biography

Antoinette Zuidweg is an alternative investments strategist in UBS’s Chief Investment Office in Zurich, where she focuses on private markets. She started her career at UBS in 2019 as a graduate and has worked within CIO for nearly two years. She also has gained experience in strategy and sustainability and impact investing. Antoinette holds a Master’s degree from Bocconi University in Milan and a B.Sc. in economics from Utrecht University in the Netherlands.

[1] References pre/post 2000, 2007 equity peaks