Chart of the Week (Jun. 21) - The "Inverted Efficient Frontier"

For this week’s Arctos Insights chart of the week, we highlight the historical total returns of different private asset classes over time and discuss a recent anomaly that could impact LP allocations in the coming years.

One of the cornerstones of modern portfolio theory is the concept of the “Efficient Frontier,” the idea that an “efficient” portfolio should seek to target the highest possible level of return for its level of risk. While this concept is generally applied to public markets, it also applies to private markets, where investors demand a premium return for higher-risk strategies (i.e., Venture Capital vs. Infrastructure). Historically, the market has been “efficient,” with the highest performing asset class (Venture Capital) outperforming lower risk strategies (Infrastructure, Senior Debt, etc.) by ~700 basis points since inception (source: Burgiss data from 1978-2023).

However, an interesting anomaly arose in 2023 amid multi-decade highs in interest rates. For the first time in over a decade, three of the top four performing asset classes in 2023 were Credit strategies (Senior, Mezzanine, and Distressed). Interestingly, Senior Credit, the lowest-risk strategy in private markets, outperformed all other asset classes and delivered an 11% net return to investors. Further, Credit strategies managed by publicly traded alternative asset managers outperformed Private Equity strategies by ~500 basis points in 2023 (15% vs. 10%) (source: Goldman Sachs).

This “inversion” has only occurred two other times since 2000: 2009 and 2012. After the GFC, the U.S. entered a prolonged period of low interest rates, straining returns for Credit-oriented strategies and driving record inflows to “risk-on” strategies. This “chase for yield” appears to be over, but if rates remain elevated and Credit strategies can continue to deliver double-digit returns, we believe this could put further downward pressure on LP’s allocations to riskier asset classes in what is already a challenging fundraising environment. It will also have implications on the target return profile of risk-on strategies, as they need to generate higher returns to justify the additional risk borne by LPs.

As LPs adjust their allocations to account for this new reality, we expect it could have meaningful impacts on the fundraising environment over the near to medium term.