How a Private Market Allocation Can Help Hedge Against Inflationary Risks

• Many private market assets contain features to hedge against the possibility of higher long-term inflation
• The underlying assets of private market strategies have the potential to exhibit better resiliency in an inflationary or rising interest rate environment
• Private market strategies can enable a focus on sectors and issuers better positioned to benefit from periods of high and persistent inflation
• A consistent private market allocation strategy could help diversify an investment portfolio while adding favorable risk-adjusted returns

Experts have varying views on whether the current rates of higher inflation will be transitory, or represent a secular trend. While many credible arguments support the transitory inflation thesis – the possibility of more volatile, and perhaps even higher inflation cannot be ruled out. Given this uncertainty, private markets possess multiple characteristics to enable investors to hedge against (and even benefit from) an inflationary environment.

The Covid-19 pandemic induced supply-side shocks and accompanying stimulus measures marked a shift away from the benign inflationary environment of the past three decades. While markets seem to expect long-term inflation to normalize in the 2-3% range, contrarian views cite structural factors such as the changes in demographics, high public-debt loads and ongoing deglobalization to argue in favor of higher inflation going forward. Regardless of which view ultimately prevails – private market strategies across credit, equity, real estate, and infrastructure are well positioned to benefit from a range of inflationary and reflationary scenarios.

Floating rates offering a hedge against rising interest rates

The ability of private credit to achieve high yields, alongside reducing volatility and interest rate risk makes it a complement to a traditional fixed rate bond allocation. The floating rate mechanisms employed by many private credit strategies – with coupons generally tied to a risk-free rate – largely mitigate the risk of rising rates. Further, the buy-and-hold nature of private credit reduces the valuation volatility of the underlying assets – appealing to investors looking to shift away from the high volatility of listed securities.

Private credit strategies could also benefit from the manager’s ability to selectively target assets that possess strong credit fundamentals and are better positioned to withstand inflationary pressures. These assets may include companies operating in resilient sectors, having market-leading positions, strong balance sheets, high margins, and pricing power. Moreover, in cases of default, private credit strategies can leverage a manager’s ability to negotiate stronger downside protections and exert control over the restructuring process to achieve favorable recovery rates.

Targeting companies and sectors positioned to benefit from an inflationary and rising interest rate environment

Private equity returns tend to be driven by a mix of value creation efforts (revenue and margin expansion) and price multiple expansion (higher exit multiples). While an inflationary and rising rate environment could potentially slow the growth of price multiples, it could also create opportunities for managers equipped with patient capital and long-term investment horizons to target resilient businesses at attractive prices and execute value creation strategies.

Companies that could be better placed to withstand inflationary forces include those with differentiated products and market-leading positions. Players operating in higher margins sectors with favorable cost pass-through dynamics – such as mission-critical services and healthcare - may show better resiliency. In contrast, firms in sectors characterized by limited pricing power - such as industrials and manufacturing – could face pressure.

Selective geographies and asset types may offer attractive yields and inflation protection while reducing portfolio volatility

Real estate has the potential to give stable income returns while exhibiting low correlation with traditional asset classes. Some long-term leases contain rent-escalation clauses that can effectively protect real incomes. Furthermore, inflation driven higher input costs can ultimately reduce the supply of new properties and put upward pressure on rentals.

Given that inflationary forces can affect real estate differently in different geographies – a broad diversification across countries could help diversify country-specific risks. The potential for robust rental growth may also exist in geographies and assets where demand is exceeding new construction activity.

Offering long-term cash yields which can be less correlated with other asset classes and the business cycle

Certain infrastructure projects can offer investors access to inflation-protected cash flows that are backed by concession agreements, contracts with inflation-indexed price escalation, or monopolistic projects with significant pricing power. The highly regulated and essential services nature of these long-term contract-backed projects helps to ensure stability and predictability of cash flows.

While multiple strategies with different risk-return profiles (core, core-plus, value-added, opportunistic, debt) exist – in general, projects that could show better resiliency during inflationary environments may include those having higher margins, pricing power, and a fixed cost base. In contrast, projects which may be more impacted by secular trends such as deglobalization and reshoring could experience greater vulnerabilities.

With unique characteristics and a full spectrum of risk-return / yield-capital appreciation profiles, the private universe offers a range of opportunities to meet a variety of bespoke investment portfolio needs.

Through a consistent private market allocation strategy across market cycles, investors can explore multiple ways to further optimize the risk-return, diversification, volatility mitigation, and liquidity profile of an investment portfolio.