2024 was, by many measure,s another poor year for private equity. Against the backdrop of flat industry assets under management and falling capital raised, annual exits have now fallen to 50% of the levels seen in 2022. Cash distributions, aided by a range of financial engineering techniques rather than true IPO activity, barely kept pace with contributions.
With it now being six years since investors last saw net positive cash flows from private equity, institutions can only cling on for so long before the capital calls become untenable. The ongoing liquidity drought is also a harbinger of further tension for those matching their liabilities as recent vintages are threatening to deliver repayment timelines far longer than the nine years that were required for pre-global financial crisis funds.
As a result, many private equity investors are now over-exposed and a sizable few have halted allocations entirely to starve out the associated risk. Private equity capital raised in 2024 was 20% lower than in 2023, and industry assets under management stalled. That fragility is further supported by the volumes traded in secondaries (an indication of forced selling), which have jumped by nearly 50% last year – but also by bankruptcies in private equity companies, which have spiked.
Those caught in the jaws of this widening cashflow gap may be tempted into further sell-offs as the issue drags on, resorting to the disposal of public equities alongside private equity secondaries to reintroduce portfolio liquidity. Such forced rebalancing does, however, come at a significant cost; not only in potential crystallised discounts to fair value, but also in the form of abandoned upside potential and allocation drift as investors are forced to move further away from long-term strategic positions.
While there might be some unavoidable need in the immediate term to increase liquidity through asset disposals, the use of derivatives to hedge equity risk can provide investors with extra defence when encountering potential cashflow mismatches, especially if market stresses intensify.
In particular, capital-efficient strategies such as portable alpha can combine growth asset exposure with a range of diversifying alternative investments, allowing investors to participate in equity markets while still maintaining defensive allocations.
However, the tightrope that institutional investors must walk is incredibly thin. As portable alpha increases in popularity, we believe allocators should act with caution. If the approach is used to increase exposure to procyclical alternatives instead of positioning portfolios defensively, then it could exacerbate problems, as was too-often the case during the global financial crisis when rising correlations and unexpected illiquidity in portable alpha strategies resulted in significant losses.
On the flipside, if used correctly, portable alpha may allow investors the flexibility to effectively structure an asset allocation that targets their long-term objectives. Such an approach can be achieved without compromising future returns by providing capital-efficient exposure to growth assets alongside diversification through liquid alternative return sources, enabling investors to absorb at least some of the liquidity pain that comes from unwelcome capital calls coinciding with market shocks.
Closing one’s eyes to the current challenges would be convenient if the market recovers from here, but the risks remain.
Private equity’s stagnation and its effect on portfolio positioning is getting worse. Continuation funds and loans against NAV are only near- to mid-term solutions, in a challenging macroeconomic environment where inflation and interest rates are proving stickier than many expected.
Challenging conditions may also be compounded by ongoing geopolitical turbulence and the trend towards deglobalisation playing out across the Western world. The result is likely to further dampen forward-looking asset returns, and only strengthens the need for built-in portfolio resilience.
At a time of heightened market and geopolitical volatility, we expect capital-efficient alternative investments to be a key tool for defensive portfolio construction among institutional investors seeking greater capacity to meet a range of liquidity scenarios without compromising their long-term goals. But asset allocators should tread carefully. History has proven that incorrectly structured or ill-advised portable alpha solutions can leave investors more – not less – exposed to equity risks despite seeking portfolio diversification, leaving wounds that may take years to recover from.
Tom Adlard is a structurer at Capstone Investment Advisors
