JUNE 2016

THE NEW PROMINENCE OF PRIVATE ASSETS TARGETING OUTCOMES IN TODAY’S MARKETS

INVESTMENT PORTFOLIO RISK MARKET S ACTIONS DESIGN MANAGEMENT REGULATORY Executive Summary

}  The over- or under-performance of private assets—now a major presence in institutional portfolios—has the potential to impact total portfolio returns as much as that of public investments.

}  Once dominated by private equity buyouts and venture capital, private asset strategies are now numerous, diverse, and able to contribute to specific investment outcomes—growth, income, real return, or a combination thereof.

} Current pricing for large, auctioned private assets is stretched. Within keystone private asset classes—private equity, credit, and real assets—we often favor opportunities in smaller markets and niche areas, where competition is lower and specialized underwriting expertise is a prerequisite.

}  Managing risk and monitoring potential over-concentrations are key concerns in building private asset portfolios. Investors can take proactive steps to gain better diversification or to hedge, but there’s no denying that it’s a resource-intensive endeavor.

Nugi Jakobishvili Global Head of Alternative Solutions for BlackRock Alternative Investors

[2] THE NEW PROMINENCE OF PRIVATE ASSETS The New Prominence of Private Assets

Targeting outcomes in today’s markets

It’s well known that private assets now play a major role in alternatives allocation may be the difference between most institutional portfolios. Private equity and real estate an organization achieving its objectives or falling short. have become mainstream investments, and the growing Allocations to private assets, moreover, are likely to interest in infrastructure, private credit and other private keep growing. Investment flows that surged in the post- sectors is widely noted. What’s less recognized is the fact financial-crisis years show no signs of abating in today’s that for many investors, these allocations have reached a low-rate, low-growth climate. A recent survey1 indicates tipping point in their impact on overall returns. that around half of institutional investors intend to The chart below shows why. Average allocations to increase allocations to real assets, and half of fixed income alternative investments, the vast majority of them private investors intended to increase exposure to private credit. funds, have grown steadily over the years. Among global These are major developments. Nearly four decades after pension funds, for example, they reached 25% of the portfolio pensions first began investing in buyout funds, private by 2015. The size of these allocations—together with the assets have attained a new prominence, distinguished by wider dispersion of results among alternatives managers, an opportunity set that has broadened far beyond private compared to traditional managers—means that their impact equity and a mission-critical role for private investments on overall portfolio performance is now nearly equal to the in portfolio performance. impact of traditional assets. Often, the difference between top quartile and bottom quartile performance for an

A MISSION-CRITICAL ROLE Increasing potential impact of alternatives allocations on global pension portfolios

Marginal Impact on Allocation Performance Dispersion Portfolio Performance (Institutional allocation to alternatives th th (Difference between 25 & 75 (Product of allocation and as % of total portfolio) percentile performance) performance dispersion)

5% Alternatives 20% Alternatives 1% 1996 95% Traditional 9% Traditional 9%

12% Alternatives 14% Alternatives 2% 2005 88% Traditional 10% Traditional 9%

25% Alternatives 18% Alternatives 5% 2015 75% Traditional 8% Traditional 6%

Source: BlackRock, May 2016. Private asset performance, from Preqin, includes all major closed-end fund types, including buyout, venture capital, real estate, infrastructure, distressed private equity, mezzanine, natural resources, and growth. Allocation data is from Towers Watson Annual Global Pension Assets Study. Traditional asset performance is that of mutual funds tracked by Morningstar’s global database. Public market dispersion represents average of lagging three-year performance. Alternatives uses 2013 as latest meaningful vintage performance.

1 BlackRock’s 2016 global rebalancing survey of 170 institutions.

TARGETING OUTCOMES IN TODAY’S MARKETS [3] MORE TO GET RIGHT—OR WRONG Contributors to the wider performance dispersion in private assets

A LOOK AT SOME KEY DRIVERS

Sourcing

Private information

Structuring and The wider array of value levers Valuation negotiation Private Public Investments and risk drivers in private markets Investments Dispersion can result in greater performance Dispersion Valuation dispersion vs. public assets Asset allocation

Asset allocation

Use (or misuse) of leverage

} Sourcing: Access to investment opportunities is selective } Valuation: Comparables are often difficult to find or rely and often made discretely. on for unique assets, requiring more work to establish intrinsic valuations. } Private information: Relevant data is largely private. Selective disclosure is not restricted, it is the norm. } Asset allocation: Includes both active allocation to public market risk premiums and assessment of the illiquidity } Structuring and negotiation: Custom structures and premium, which changes significantly over time. security features are more widespread in privately negotiated transactions, and pricing power may be derived } Use (or misuse) of leverage: Leverage and debt covenants from non-economic factors, such as time pressures to are more varied than in public markets. get a deal done.

Source: BlackRock, May 2016.

[4] THE NEW PROMINENCE OF PRIVATE ASSETS We believe that this new age of private assets calls for a focus of the investment on the intended risks and new, more comprehensive view of investment strategy— desired outcome. one that looks beyond siloed approaches. Its three, mutually But that’s just a first step. To fully optimize a portfolio of supportive elements are: private assets, it’s necessary to move beyond the asset-class } A focus on outcomes. Investments in private assets should view and compare dissimilar investments to one another. not be made simply on the promise of outsized returns. In public markets, established metrics, widely available data, Rather, they should be defined by their expected alignment and standard analytics make such comparisons relatively with and contribution to portfolio objectives, e.g., growth, straightforward. With a few keystrokes, equity investments in income or real return, and combinations thereof. diverse industries and geographies can be compared in terms } Attention to relative value. Investors in private assets are appropriate for the sector. The instant availability of often susceptible to making binary, standalone evaluations operating margins, revenue estimates, and an array of price as opportunities arise—is this a good investment, yes or multiples and financial ratios is taken for granted. Similarly, no? But having more options compels a stronger emphasis bond investors can immediately access interest coverage on the relative, not absolute, attractiveness of private ratios, key rate durations, convexity, and so forth. investments, many of which may indeed be good on a On the private side, comparisons are harder, and valuation standalone basis. models are built from scratch. Metrics are largely asset-class } A more specific view of risk. Identifying the underlying specific. Data is scarce and often proprietary. Reports tend drivers of risk and return of private assets can help avoid to reflect the siloed views of disparate managers focused the unintended concentrations that broad asset class solely on their own specialties. Still, an optimized private labels sometimes hide. Because the risk of owning a fully asset portfolio requires such comparisons. leased trophy office property is categorically distinct from The more specific view of risk is equally important, and the risk of owning equity in a ground-up hotel development, equally challenging to achieve. It’s hard to know if a risk is we need to go deeper than simply referring to both as real attractively priced without a clear idea of what the risk really estate risk. Familiar technology from public markets, such is, but achieving that visibility across a diversified private as multifactor models, helps us get more specific for asset portfolio requires dedicated data-collection and private assets as well. modeling resources that are not a part of the investment If this approach sounds ambitious, it is. None of these criteria infrastructure in most organizations. Moreover, such can be met with the ease, or often to the degree, that is portfolios, while seemingly diversified, may also contain possible in public markets. There are good reasons why unintended concentrations of risk. private asset premiums exist. Indeed, these premiums are Is it possible to target private asset premiums with more closely related to the greater dispersion in results for private of the transparency and flexibility investors enjoy in public asset managers compared with public asset managers. markets? We believe that with the right mindset—and Public markets are highly efficient. Information abounds, and enough work—the answer is yes, and that our three is quickly reflected in security prices, making it harder to find criteria for investing in private assets can be met. We also alpha but also easier to judge valuations and map investments believe that, for many investors, the bigger impact these to desired outcomes. With private assets, managers pursue assets can now have on their overall results makes the effort alpha by pulling the many levers that complexity, reduced highly worthwhile. liquidity and proprietary research and deal-flow make In the pages that follow, we outline our approach. We start available. There’s simply more to get right—or wrong—on with a briefing on four keystone private asset classes, the private side. See the chart on the previous page. detailing current opportunities and the range of exposures Investors naturally aspire to dwell in the top quartile of this available in each. We then switch to an outcome perspective, wider dispersion. One way to improve the chances of landing using model portfolios to illustrate how investors can make there is to take full advantage of the greater number of levers the most effective use of these exposures. We conclude by available in each investment. By using these levers to pursue examining risk, and the challenges of—and potential rewards a greater degree of customization, they can sharpen the for—managing complexity.

TARGETING OUTCOMES IN TODAY’S MARKETS [5] Current opportunities

Fundraising for private asset strategies last peaked in 2008, Yet today’s private institutional markets are far more as the global financial crisis was unfolding. After a trough the than adjuncts to public markets. A growing number of following year it has come back strong, with a more diverse investments—for example, litigation finance or pharmaceutical mix of asset classes represented. (See the chart below.) royalties—don’t have a public-market equivalent, and have little or no correlation with public-market beta. Indeed, most of the The growth since 2009 owes much to the twin catalysts niche private opportunities targeted by institutions do not have of low rates and regulatory restraints on banks: The former strong representation on public exchanges. launched a global hunt for yield, while the latter left a financing void in several sectors. But there are also longer- As private markets expand and debt and equity exposures term trends at work. The history of investing, and especially within them multiply, an interesting thing happens: of institutional investing, shows an ongoing quest for new They come to resemble public markets in offering an array investment frontiers. Public markets, though vast, serve only of investments one can use to target not just capital a portion of the globe’s financing needs, and it was probably growth, but a full range of possible outcomes. inevitable that institutions would look beyond them. As of May 2016, pricing across large private asset classes The early 1980s was for some institutions a time of initial steps has been stretched in most developed markets. Exposure into venture capital and private equity buyouts, capital-growth to illiquid beta, i.e., broad participation in the largest funds strategies closely linked to public markets. As the first age of across private asset classes, is at this point in the economic private assets progressed—through regulatory changes to cycle unlikely to deliver above-average illiquidity premiums, we ERISA rules that encouraged flows, the advent of new believe. We favor more specialized opportunity sets within each investment structures, data sources and benchmarks, and asset class, believing them better suited to produce excess some inevitable booms and busts—this interplay between returns over public markets along with the diversification public and private has remained a central dynamic. benefits that accompany such idiosyncratic exposures.

THE EXPANDING UNIVERSE Growth of private investment strategies, 1985-2015

Private Credit Real Estate Private Credit Real Estate Private Credit

Venture Buyouts Buyouts Energy Buyouts Infrastructure

700 Venture Real Estate 600 Venture 2000 2015 1985 Mezzanine 500 Special Sits/ Distressed 400 Direct Lending Energy 300 Infrastructure RE: Debt 200 RE: Opportunistic RE: Value-Add ANNUAL FUNDRAISE ($BN) ANNUAL 100 RE: Core and Core+ Venture 0 Buyouts 1985 1990 1995 2000 2005 2010 2015

Source: BlackRock, May 2016. Data from Thomson One, Preqin; shows fundraising for all private closed-end funds in the Preqin universe, excluding funds of funds, secondaries and hedge funds.

[6] THE NEW PROMINENCE OF PRIVATE ASSETS PRIVATE EQUITY Private equity today plays a significant role in global capital PRICING MIDDLE-MARKET BUYOUTS markets and as a growth-seeking investment in most Average EBITDA multiple for European and U.S. deals institutional portfolios. As of 2015, the average allocation for 12x institutions in Preqin’s global database was 9.2%, with an average target of 10.6%. 10x

Much of the current institutional commitment to private equity 8x is uninvested. Dry powder in buyout funds is around $490 billion, Preqin says, the result, in part, of a record $428 billion in exits in 2013 and institutions re-investing in an asset class 6x that has performed for them. Not surprisingly, deal activity dropped off sharply in the volatile first quarter of 2016. 4x

With inexpensive debt helping to fuel competition for quality 2x buyouts, private equity has resembled a seller’s market for the past few years. S&P reports that average purchase multiples in Europe and the U.S. were 10.1 and 10.5 times 0 2004 2006 2008 2010 2012 2014 1Q16 EBITDA, respectively, in the first quarter of 2016, above their pre-crisis highs. In this environment, value is more likely to be Europe US found in specialized areas, for example, transactions based Source: S&P Capital IQ, 2016. Chart shows average purchase price multiple of pro on bolt-on or roll-up growth strategies, or relying on specific forma trailing EBITDA for buyouts of companies with EBITDA of less than €/$50M. industry expertise or turnaround skills. We prefer the middle market, where purchase prices are lower (see chart to the right). Competition from corporate acquirers is less intense Unlike private equity, private credit offers investors the potential in the middle market, and we believe there are opportunities for significant income distributions, with capital appreciation to purchase smaller companies outside of the typical often serving as upside rather than the main event. bidding processes. Global private credit fundraising reached a peak of $99 billion Opportunities in growing (and less loved) geographies in Asia in 2008, contracted to $26 billion the next year and then and peripheral Europe are also worth considering, both in climbed back to $95 billion in 2015. (See chart on page 8.) their own right and because diversification—by geography as The larger number of funds active in the post-crisis period well as by strategy and vintage year—is no less important in (an average of 115, compared with 66 in prior years) shows a private equity portfolio than it is in public equity investing. a broadening market, with credit funds, hedge funds and other new participants continuing to enter the space. Low Early 2016 saw some large, highly levered deals uncertain of global interest rates help to motivate participants. But the securing debt financing. As we detail in the next section, the deeper structural drivers, together with the fact that these drying up of cheap financing is opening opportunities on the are mostly floating-rate loans, point to a long-term role in credit side for lenders with the ability to be flexible. the sector for institutional capital.

PRIVATE CREDIT Asset-raising has so far exceeded deployment rates, partly Private credit has claimed a larger space on the map of because early post-crisis funds targeted asset sales by institutional asset classes in recent years, mainly because deleveraging European banks that proved slow to materialize. of expanding opportunities to finance middle-market While those sales may finally be getting underway, they companies. With traditional lenders pulling back in response are subject to heightened competition, and we are more to regulatory changes—especially higher capital standards interested in the future funding needs of the companies for banks—private credit has evolved beyond an initial focus those banks are now less able to serve. on lending to private-equity backed firms to include a range The current supply-demand picture makes us cautious on of investments, from direct and distressed lending to broadly syndicated opportunities. We think value is more likely to collateralized loan obligations and specialty finance. be found in middle-market loans that can be tailored to the

TARGETING OUTCOMES IN TODAY’S MARKETS [7] transactions that include unitranche financing (wherein a A BROADENING MARKET single underwriter takes both senior and subordinated Global private credit fundraising 2000-2015 positions) and stretch senior loans (which combine elements 160 160 of both asset-based and cash-flow lending). Such loans are helping to move some buyout deals forward, and lenders 140 140 flexible enough to provide them enjoy pricing power. Post-crisis avg. 120 120 # of funds = 115 Private credit is an especially fast-moving sector with, we 100 100 believe, much growth ahead of it—including in Europe and Asia, where banks still provide the great majority of corporate 80 Pre-crisis avg. 80 credit, but will be unable to do so in the future. # of funds = 66 60 60 REAL ASSETS: PROPERTY 40 40 FUNDS NUMBER OF With average allocations to real estate approaching 10% in institutional portfolios around the globe2, it’s hard to

AGGREGATE CAPITAL RAISED ($BN) CAPITAL AGGREGATE 20 20 recall that the institutional move into property was a long 0 0 and gradual process. While some insurers set up separate 2000 2003 2006 2009 2012 2015 accounts to enter commercial property in the 1960s, it Aggregate Capital Raised ($BN) Number of Funds wasn’t until the late 1980s that commingled funds started to materially increase institutional access. Source: Preqin, May 2016. Strategies included: Direct lending; distressed, mezzanine, special situations and venture debt. Within real estate, an investor can pursue a high-risk, high- potential-growth investment via an opportunistic strategy; a medium-risk-and-growth investment via a value-add strategy; borrower’s situation as well as the lender’s needs. We’re also an income-generating investment via a core strategy; or interested in loans backed by receivables or hard assets such income via senior mortgages or mezzanine debt. The as equipment or machinery, and other forms of specialty attractiveness of these options varies with economic and other lending that require special underwriting expertise to value cycles. (See chart below.) the collateral. All real estate is local, but we see a broad, global trend: In the buyout world, the pullback of some senior lenders is Post-crisis flows have compressed cap rates in many parts creating increased opportunity in the senior part of the of the world, especially for trophy properties in global hubs capital structure. We’re seeing selected opportunities in such as New York, London and Shanghai.

PROPERTY PREFERENCES Investment styles cited in INREV’s annual survey

100

80

60

40

20 % OF RESPONDENTS % OF

0 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Opportunistic Value-Add Core

Source: INREV, 2016. Data is global, from INREV Investment Intentions Survey. The 2016 survey had 345 respondents.

2 According to the Institutional Real Estate Allocations Monitor from Cornell’s Baker Program and Hodes Weill & Associates.

[8] THE NEW PROMINENCE OF PRIVATE ASSETS In the U.S., 2015 saw improving occupier demand and rent An established toll road issuing senior debt, for example, growth. With the real estate cycle well advanced, however, our could be an investment-grade income strategy. One that’s approach is defensive. We favor core risks and investments with still in the planning stage in an emerging market would the potential for stable income supported by continued occupier probably get the opportunistic label. demand. On the debt side, a wave of maturities in commercial As in real estate, competition for core assets is keen, and mortgage-backed securities is creating opportunities to provide prices on brownfield assets such as established airports mezzanine debt to sponsors and developers on favorable terms. reflect this. Some investors are looking beyond heavily bid In January, data provider Trepp counted more than $205 billion core projects and seeking incremental yield in core-plus in U.S. CMBS conduit loans coming due by 2018. New CMBS strategies—a reasonable tradeoff, in our view, since the issuance, expected to be well below $100 billion this year, is construction risk entailed can be mitigated by thorough unlikely to meet the refinancing need. due diligence and robust contracts. In Europe, growth is slower and interest rates remain lower, While some governments have been notoriously slow in but the UK, German and Nordic markets in particular have advancing private infrastructure investment, others are trying attracted strong capital flows. Investor demand for core prime to promote it, with the UK’s new Infrastructure and Projects real estate has widened the price gap between prime assets Authority and the newly proposed Canada Infrastructure Bank and the rest of the market. Together with recovering occupier the latest in a series of initiatives. Nevertheless, the challenge demand for space in good quality buildings—and a shortage for many investors has been in identifying addressable markets. of such buildings—this sets up an opportunity for value-add strategies that revamp and reposition Grade B properties as Among the most active areas is renewable power, with $268 Grade A. Value-add equity strategies may also prove attractive billion in transactions over the five years ending in Q2 2015, in China as the country continues its challenging transition according to Dealogic. Renewable power is benefitting from away from heavy industry and toward services. multiple tailwinds, including the need to retire and replace coal-fired capacity, the growing cost-competitiveness REAL ASSETS: INFRASTRUCTURE of wind and solar generation, and policy support from governments, including a recently extended tax credit in No private asset class has been more shaped by the financial the U.S. Equity investors in renewables typically seek and regulatory climate of recent years than infrastructure. A long-term yield with potential for capital appreciation, younger sibling to real estate in the real assets category, it has inflation protection, and the diversification benefit that the potential to grow as large, with long-term global need for comes from adding wind or sunshine risk to a portfolio. infrastructure investment measured in the tens of trillions of dollars and the need theoretically addressable by institutions estimated at about $200 billion per year by S&P in a 2014 study. INVESTMENTS WANTED Most institutions have infrastructure allocations well below Average current and target allocations to infrastructure their targets. As of 2015, endowments were on average 10 targeting a 6.1% allocation, but had only a 4.1% exposure. 8.7 8 For public pension funds the numbers were a 5.1% target 6.6 vs. a 3.2% actual. (See chart to the right.) 6 6.1 5.1 4.3 The asset class is a large and varied one, spanning sectors 4 4.1 3.9 3.9 3.2 2.9 from power and energy to transportation and social 2.5 2.5 infrastructure such as hospitals. While the benchmarks 2 AVERAGE ALLOCATION TO TO ALLOCATION AVERAGE and data sources that exist in real estate are still absent, 0 infrastructure has come a long way in a short time. AUM) A % OF (AS INFRASTRUCTURE Plan Plan Today’s roster of strategies closely resembles real estate’s, Scheme Company Insurance running from lower-risk, income-oriented to higher-risk, Foundation Endowment Pension Fund Pension Private Sector Private Public Pension Public

growth-oriented, and using the same nomenclature: debt, Superannuation core and core plus, value-add and opportunistic. Average Current Allocation Average Target Allocation

Where an investment falls on this spectrum has much Source: Preqin Infrastructure Online, December 2015. more to do with its financial and risk profile than its sector.

TARGETING OUTCOMES IN TODAY’S MARKETS [9] Emphasizing outcomes, managing risk

Many institutions apply an asset-class perspective when coverage ratios) to begin bringing their relative merits they invest in private markets—for example, by grouping real into focus. estate equity and real estate debt together. There is sound Switching the perspective from asset class to desired logic to this approach, since in either case we must outcome can help to unlock the full potential of private underwrite and value the property with an understanding of assets. To illustrate how, and to give a sense of what can net operating income, a view on the tenants, the lease be accomplished with the wide range of exposures now structure, and so forth—and a mezzanine lender with bad available, we present three illustrative outcome-focused luck may suddenly become an equity owner. portfolios and detail their components. See the chart below. From an outcome perspective, however, real estate debt Portfolios like these can be implemented in the real world often has more in common with infrastructure debt than by a multi-asset manager with a carefully defined mandate it does with real estate equity. And while comparing and and access to the full spectrum of private assets. In actual valuing the two types of private debt requires more practice, the investment choices depend partly on market specialized expertise and proprietary research than conditions—which is to say, where the best values are—and comparing bonds issued by Pfizer with bonds issued by the portfolios are managed dynamically, adjusted (within Johnson & Johnson, that specialized expertise can be used liquidity constraints) as conditions change. to establish common metrics (e.g., loan-to-value and interest

OUTCOME-ORIENTED PRIVATE-ASSET ALLOCATIONS Composition and characteristics of three illustrative portfolios

Growth Income Real Return Illustrative growth portfolio Illustrative income portfolio Illustrative real return portfolio Special Sits RE: Core and Core+ Agriculture RE: Multi-family Energy Medical Care Buyouts Special Sits Debt RE: Value-Add Infra Equity

RE: RE: Debt Venture Residential RE: Floating RE: Value-Add OPPORTUNISTIC RE DIRECT LENDING Infra Equity INFRASTRUCTURE Rate Debt & MEZZ

Contributions to growth portfolio Contributions to income portfolio Contributions to real return portfolio Return: asset enhancement to generate Return: delivers wider spread off floating Return: long-dated, stable cash flows price appreciation rate base vs. public comparables with significant linkage to inflation Risk: project management / execution, Risk: spread / credit exposure Risk: idiosyncratic project-level with underlying market exposure at exit Diversification: deal-level structuring operational risk Diversification: asset-specific drivers provides downside protection and lower Diversification: low correlation with (e.g., location, type, etc.), largely beta to external risk factors (e.g., equity) spread and equity risk factors uncorrelated with primary risk factors

Source: BlackRock, May, 2016. These allocations are hypothetical and for educational purposes only. There is no guarantee that investments described above will be available in the future, or that, if available, they will be profitable.

[10] THE NEW PROMINENCE OF PRIVATE ASSETS Regardless of whether investors choose to go the multi- generation at suitable risk levels, provided issuers have asset manager route, thinking about private assets from conservative loan-to-value ratios—say, a 20% to 40% an outcome perspective can bring significant benefits. equity cushion. As a closer look at the model portfolios shows, the Direct lending and mezzanine financing target wider advantages may include greater diversification and a spreads off of floating rate bases compared with public potentially improved risk-return profile. equivalents. These assets add credit risk to the portfolio, The growth portfolio is the senior member of our trio. At one but deal-level structuring can improve downside protection time it was pretty much the only option for private asset and lower beta to equity markets. investors, and it consisted almost entirely of buyouts and The real return portfolio allocates to strategies and venture capital. Those two still play an important role in our transactions that explicitly seek to deliver a premium over updated growth portfolio, but are now pieces of a larger and realized inflation, with the goal of protecting long-term more balanced pie. purchasing power. Despite the importance of inflation to Value-add and opportunistic real estate strategies aim to liabilities, a low inflationary environment has made many produce long-term value through asset enhancement, investors complacent on the inflation front. Yet it is with investors seeking a premium for bearing project unexpected increases in inflation that investors most management and execution risk as well as underlying need to guard against. market exposure at exit. Asset-specific drivers such as Not surprisingly, real assets feature prominently here. local market dynamics and onsite execution risks can be Illiquid investments (e.g., commercial real estate, power diversifying to a larger allocation in alternatives. plants, pipelines) are favored, since their revenue sources are Other growth-seeking investments, including energy more often directly linked to inflation. Moreover, valuations and infrastructure equity, can play a role here as well. of illiquid real assets are primarily driven by fundamentals, For example, providing rescue financing to a cash-strapped shielded somewhat from market volatility driven by exploration and production company may yield private equity- technical factors. like returns. Infrastructure equity projects with construction In our view, multifamily real estate equity should play an risk may also have appropriate risk-return profiles for important role in a real return portfolio. With 41% of the this portfolio, and can potentially add well-rewarded U.S. consumer price index comprised of housing, there idiosyncratic risks. is a strong correlation between multifamily real estate The income portfolio mixes debt and equity investments, and inflation. aiming to generate yield in excess of what’s available in Infrastructure is an important component because certain public credit markets. Significant collateral and cash flow projects may provide contractual linkage to inflation via coverage are designed to provide downside protection in power-purchase agreements that include consumer price the event of a negative market shift. index step-ups. Project level operational risks need to be Core real estate provides a mix of income and capital managed with expertise, but are largely uncorrelated with appreciation, with a focus on high-quality, long-term cash credit and equity market risks. flow. It introduces real estate equity risk into the portfolio, but attention to collateral value can make these investments relatively secure. Real estate debt may offer good income

[10] THE NEW PROMINENCE OF PRIVATE ASSETS TARGETING OUTCOMES IN TODAY’S MARKETS [11] THE RISK-CENTRIC VIEW discretion to invest across sectors and geographies, the managers include the following investments in their funds: The value of deliberate and diversified risk exposures comes through clearly in our model portfolio exercise. These are } The private equity manager invests in distressed energy important considerations no matter how an allocation to exploration and production companies, seeking to buy low private assets is bucketed. amid broader energy market turmoil.

Investors routinely consider how correlated their private } The real estate manager seeks to capitalize on the asset investments are to public market betas, since widening cap rates in Houston driven by decreased demand diversifying their public market exposures is one of the for high-end commercial space. reasons they come to private assets in the first place. } The credit manager structures a bespoke second-lien debt However, many pay less attention to the unintended tranche with an oil-field services company that faces concentrations of risk that may exist among multiple private difficulty issuing debt in the public market. asset allocations. While the investments may all make sense and offer These concentrations develop for two reasons. The first is attractive risk/return trade-offs on a standalone basis, the that alternative managers generally take more concentrated investor may now have an outsized bet on the energy sector positions compared with public market managers. Second, embedded in the overall private assets allocation. because they do not manage to a benchmark, they enjoy significant flexibility in investing across sectors, industries As the chart below illustrates, this can happen in practice. and geographies. Often, when one asset class sees The chart uses aggregate global fund-raising and fund- opportunity in particular industries and geographies, others investment data from 2000 to 2015. On the left, we show see it as well. investor allocations to private energy-dedicated funds, equal to 4.6% of total commitments to alternatives on average. Consider the case of an investor seeking a diversified On the right, we show the total energy exposure investors alternatives exposure who allocates to private equity, real had. Although less than 5% of the average portfolio is estate, and private credit. With broad mandates and the

HIDDEN CONCENTRATION Intended vs. actual exposure to energy sector in private funds

COMMITTED CAPITAL INVESTED CAPITAL 16 16 120

14 14 105

12 12 90

10 10 Average Total 75 Exposure to 8 8 Energy = 7.6% 60

6 Average Total Commitment 6 45 to Energy = 4.6% 4 4 30 COMMITMENTS TO PRIVATE FUNDS PRIVATE TO COMMITMENTS WTI CRUDE SPOT PRICE ($/BARREL) WTI CRUDE SPOT 2 2 15 A % OF TOTAL INVESTED IN PRIVATE ASSETS IN PRIVATE INVESTED TOTAL A % OF CAPITAL INVESTED INTO ENERGY-RELATED DEALS AS DEALS ENERGY-RELATED INTO INVESTED CAPITAL

CAPITAL COMMITTED TO ENERGY FUNDS AS % OF TOTAL % OF FUNDS AS ENERGY COMMITTEDTO CAPITAL 0 0 0 2000 2003 2006 2009 2012 2015 2000 2003 2006 2009 2012 2015

Energy Funds Energy Funds Non-Energy Funds WTI Price (right axis) Source: BlackRock, May 2016, using data from Preqin, Thomson One, Real Capital Analytics. Chart on left shows committed capital to global energy-focused funds each year, relative to total global amount raised by all private, closed-end alternative funds. Chart on right shows invested capital for global energy funds and non-energy funds into energy-related investments, as a percent of total global private closed-end fund deployment in each year. Oil price is that of West Texas Intermediate (WTI).

[12] THE NEW PROMINENCE OF PRIVATE ASSETS RESOURCE INTENSIVE Staffing/AUM ratios for selected alternative and traditional investment managers

Private Alternative Investments Traditional Investments 1,000

800

600

400

200 $350 million of AUM per $1.8 billion of AUM per

NUMBER OF INVESTMENT PROFESSIONALS INVESTMENT NUMBER OF investment professional investment professional 0 0 500 1,000 1,500 2,000 2,500

AUM ($BN)

Source: BlackRock, May 2016. Data is from public filings and company websites of four leading alternative investment managers, with assets under management between $95 billion and $350 billion, and four leading traditional asset managers, with AUM between $850 billion and $1.5 trillion.

allocated to energy via the energy-dedicated funds, an Managing risk is proactive and spans the entire investment additional 3% of the portfolio actually consisted of energy- process, so that bottom-up views coalesce into a holistic related investments—from “diversified” private equity view of portfolio risk. Private assets can’t always be sold allocations, real estate deals linked to the energy market, easily, so risk management for illiquid portfolios requires private debt, and infrastructure. advanced planning and thinking through available liquidity for new investments or ongoing hedge programs. Ultimately, So while investors received what they expected from their managing risk for private assets is like flying a plane. It takes energy allocation, they received an additional 65% of sector experience and good judgment to handle changes in exposure from non-dedicated energy strategies. conditions—but a good instrument panel and parachute are These unintended risks stem from traditional practices in worth their weight in gold. private investing that need remediation, whether one is investing in transactions directly (including co-investing), A HANDS-ON ACTIVITY or investing in funds. Establishing underlying risks for each Managing complexity and illiquidity, the hallmarks of private investment (by linking valuations with multifactor risk assets, takes work—and work, nearly everyone would agree, models) and providing transparency in fund reporting are should be properly compensated. basic elixirs for any manager of private assets. For direct investments, factor models allow us to create scenario While illiquidity premiums fluctuate considerably over time analyses for cash flows and valuations, while ample detail they are, in a very real sense, the potential reward for all the from fund managers helps investors to test and validate their effort that goes into sourcing, evaluating, and structuring risk models for these funds. private deals. How much more resource-intensive are private assets? The chart above provides a rough measure, Once risks are identified, they can be managed with comparing the ratio of investment professionals to assets diversification through new investments, or by hedging. under management at traditional and alternative asset Explicit hedge or insurance costs should be built into the managers. By this metric, private assets in general are valuation model and any pro forma portfolio analysis about five times more resource-intensive than their (pre- and post-hedge). public counterparts.

TARGETING OUTCOMES IN TODAY’S MARKETS [13] The resources handle a host of tasks. A renewable power Approaches to investing in private assets are bound to investment might call for assessing wind patterns at a site in keep evolving. In the days when allocations were smaller Kansas. A real estate investment might require inspecting and performance didn’t move the needle for overall the physical assets and traffic patterns of shopping malls in outcomes, investors rightly focused most of their attention Beijing. A private credit investment might depend on months and resources on their public holdings. But as allocations of diligence of the management team, business plan and to private strategies grew, the performance of private assets of a middle-market company in Germany. All of this assets mattered more and more—bringing us to the comes before the equally important process of structuring current state of play, wherein the impact of underperforming the transaction in a way that seeks the desired exposures or outperforming in private investments is achieving and outcome. And, of course, the whole effort takes time. parity with the impact of public asset performance. It can take six months to finalize a private investment that Few topics get more attention than the future of public will make up only 0.3% of a large asset owner’s total portfolio. financial markets. With abundant information and the A few of the world’s larger investors have the internal enthusiastic help of the media, investors are well resources to directly make and monitor their own private accustomed to debating scenarios and their implications. investments. For most institutions, however, a greater Are stocks overpriced? Will high yield defaults pick up? reliance on private assets will entail determining an Will active funds outperform passive funds? This long- appropriate mix of internal and external resources and running conversation has only grown more intense amid figuring out how best to work with outside managers. the unusual monetary policy conditions of recent years. Private investments, relatively speaking, have yet to see their Some investors, recognizing they need more visibility fair share of mind or airplay. But when the stakes become into their private asset allocations, are limiting the number high enough, investors are good at playing catch-up. of managers. Some are adding internal talent: A 2014 Economist Intelligence Unit global survey of institutional There’s no certainty, of course, on what the future will investors found nearly a third of them planning to add hold for returns—on either the public or the private side. resources to support investment in real assets. These moves But there is some certainty that effective management of are aimed at improving efficiency as well as their ability to private assets will matter greatly to that future, and will target outcomes. require today’s investors to make adjustments. As usual, Yogi Berra got it right: The future ain’t what it used to be.

[14] THE NEW PROMINENCE OF PRIVATE ASSETS TARGETING OUTCOMES IN TODAY’S MARKETS [15] WHY BLACKROCK® BlackRock helps people around the world, as well as the world’s largest institutions and governments, pursue their investing goals. We offer:

} A comprehensive set of innovative solutions, including mutual funds, separately managed accounts, alternatives and iShares® ETFs } Global market and investment insights } Sophisticated risk and portfolio analytics

We work only for our clients, who have entrusted us with managing $4.73 trillion, earning BlackRock the distinction of being trusted to manage more money than any other investment firm in the world.*

* Source: BlackRock. Based on $4.73 trillion in AUM as of 3/31/16.

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Lit. No. INST-PRIVATE-616US 169123T-INST/UIM-0382