The report, Private Markets and the Asset Allocation Imperative, highlights that these limitations have become increasingly consequential as investors dedicate more capital to illiquid investments such as private equity, private credit and infrastructure.
For the case of private equity, this now represents around a notable 10th of all public market capitalisation globally.
“Institutional investors face increasing challenges in integrating private market investments into their strategic asset allocation,” Ian Lyu, director of client consulting at bfinance Australia, said on the findings.
“With private equity now representing around 10 per cent of total public equity market capitalisation – up from less than 5 per cent in 2010 – understanding return expectations and the illiquidity premium is crucial.”
According to the firm’s recent Global Asset Owner Survey, nearly half (47 per cent) of the participating investors expect a reduced illiquidity premium. The report suggested that private market investors should assume a 2 per cent premium for buyout funds, and a 3 per cent premium for venture capital.
This shift, bfinance underscored, challenges the assumption that private markets will consistently outperform public markets, and sparks the question of appropriate risk-adjusted returns.
Expounding on the latter, the investment consultant raised concern for the limitations of internal rate of return as a performance measure, citing their sensitivity to cash flows as being inappropriate for asset allocation.
“Instead, time-weighted returns can be a more reliable measure for asset allocation decisions,” the report said.
“Volatility estimates must also be adjusted to reflect the true risk profile of private assets, as artificially smooth return patterns can lead to overstated diversification benefits.”
Lyu added that private market benchmarks fail to capture the true volatility and risk-adjusted returns of private markets, leading to potential misallocations.
For Australian investors, he said this is particularly relevant as institutional and wholesale investors continue to expand their exposure to private equity, private credit and infrastructure.
“With a shifting fundraising environment and evolving exit strategies, investors should look to re-evaluate their assumptions about risk and return,” Lyu said.
While no strategist possesses a “crystal ball”, bfinance argued it’s better “to be roughly right than precisely wrong” when it comes to the likes of private equity.
As such, the firm said that the most robust route lies in combining well-modelled public equity return expectations with an appropriate premium and a “public-plus-premium” approach to investor governance.
“By applying a structured ‘public-plus-premium’ approach, investors can develop more robust private market allocations that appropriately balance illiquidity risks with long-term return potential,” Lyu added.
Nonetheless, bfinance pointed out the diversification benefits of private markets, particularly as IPO activity continues to decline as more companies opt for take-private transactions.
Despite both markets being sensitive to macroeconomic forces, the report noted that a decline in the interconnectedness between the two can create a valuation divergence.
“Given the recent increase in the concentration of global stock markets, investors’ desire for diversification through private markets may be elevated,” bfinance said.
“Despite uncertainty, private markets remain a vital component of institutional portfolios,” it added, but noted the importance of strong governance and clear allocation frameworks so as to better equip investors to navigate the landscape.
“Consistent investment strategies, GP-led secondaries and semi-liquid structures are reshaping opportunities, while slower fundraising and high valuations may improve investor terms. Active oversight and disciplined decision making will be key to long-term success.”
