Alternatives: The Area of Opportunity

With public fixed income facing substantial interest rate and spread widening risk and public equities facing elevated valuations, investors should look to the private markets for potential opportunities. Private markets typically offer illiquidity and complexity premia that most public markets lack, often resulting in relatively attractive risk-return profiles.

Private debt investments in asset-based strategies (including both cash-flowing and hard assets) generally provide exposure to well-collateralized senior debt with relatively high coupons. Opportunistic and special situations credit strategies may capitalize on complexity and provide exposure to assets that are often uncorrelated to broader public markets.

We believe that private equity opportunities exist among three types of strategies: lower middle market buyout, secondaries and sector/strategy specialists. Lower middle market buyout managers operate in a relatively less efficient market and are thus able to enhance returns with strong deal sourcing. Additionally, smaller, less mature companies typically present opportunities for relatively straightforward operational improvements that unlock value. Secondary private equity strategies provide industry and vintage year diversification and mitigate both the j-curve and blind pool risks generally associated with primary private equity. Managers who specialize in a specific sector (e.g., health care, technology) may be able to add substantial value to portfolio companies due to their extensive industry-specific experience and networks.

For these reasons, we recommend that investors able to allocate to illiquid assets build an overweight position relative to policy target in both private equity and private debt while maintaining strategy and vintage year diversification, as the market opportunity in both asset classes will likely continue through 2017.