An Alternative Perspective: Past, Present, and Future

From its modest beginning as an acquisition strategy largely known as ‘boot strapping’, the Alternatives industry is now expected to grow to more than $24 trillion in assets in 2028 from $15 trillion in 2022. While these headline numbers may sound outsized in absolute terms, the current Alternatives market is actually still less than 11% of total global GDP and only 2.4% of total global financial assets. Importantly, though, there is no one Alternatives asset class. Rather, KKR’s 48 years of experience in the Alternatives arena reinforces our view that each asset class has unique characteristics in terms of expected return, risk, yield, liquidity, and capital requirements that require a closer look to better understand the different benefits that each asset class can bring to a portfolio. Some of the asset classes may serve more of a growth and capital appreciation purpose, while others may protect portfolios against inflation and/or provide stable income. Some strategies may offer a combination. Moreover, the spectrum of characteristics is wide and getting even wider, as the industry finds new ways to deliver value to its end-users, many of whom are looking for ways to ensure a heightened sense of retirement security. Against this backdrop, we think that sharpening one’s understanding of portfolio construction with and without Alternatives as well as across the different categories of such investments is increasingly essential to delivering robust performance outcomes in the years ahead. However, before looking further into the future about the role of this distinct segment of the global investment management industry, we also think understanding the past and the present is also key to forming a proper “Alternative Perspective”.

In 1976, Henry Kravis, George Roberts, and Jerome Kohl- berg left Bear Stearns and hung their shingle, opening Kohlberg Kravis Roberts, or KKR. Relying on their own $120,000 seed investment and the help of outside deal supporters along the way, they initially used an approach called ‘boot strapping’, ultimately creating an investment management business that is now commonly referred to as Private Equity. Together, these three gentlemen not only helped to establish the Alternatives asset class but also transformed the industry from its somewhat misunderstood beginnings to one that now touches many parts of the global economy and is highly sought after by investors.

While the Private Alternatives universe is much broader than Private Equity, we are not totally surprised to hear investors and commentators use that term as a ‘catch-all’ phrase to describe all the various activities behind which private capital now invests. However, we view this narrower focus as a missed opportunity, given the Private Alternatives (Alts) industry now extends across not only Private Equity but also Venture Capital, Private Credit, Infrastructure, Natural Resources, and Real Estate. As we show in Exhibit 1, there are now more than $15 trillion of assets estimated to be under management in the space.  Interestingly, though, while $15 trillion may sound large in absolute size, it is less than 11% of total global GDP and only 2.4% of total financial assets.

Why has the industry enjoyed such explosive growth, and why do we see this trend likely surpassing the current level of investment, reaching at least an estimated $24 trillion by 2028? We think there are three key reasons: a continued demand versus supply imbalance, the illiquidity premium, and diversification benefits.

EXHIBIT 1: The Size of the Alternatives Industry Is Poised to Increase 2.5 Times by 2028

Size of the Alternatives Industry: 2018-2028, US$ Trillions

EXHIBIT 2: Governments in the Developed World Are Now More Levered, Which Likely Means That the Private Sector Will Need to Fund Growth in Key Asset Classes Such as Infrastructure

Advanced Economies Government Debt as a % of GDP

1. The need for private capital remains outsized.

We think governments across the globe are being challenged simultaneously by historic fiscal constraints, energy transition needs, and geopolitical competition. So, as we discuss in much more detail below, private investments have emerged as a critical source of capital across a variety of industries. Just consider the post- pandemic increase in the need for infrastructure, for example, where demand for capital far exceeds what governments can provide to stand up transmission lines, connect data, build supply chain resiliency, and update existing infrastructure. One can see this in Exhibit 4. There is also the trend towards new products across the Alternatives universe that are not already captured in the current $15 trillion estimate, including new parts of Asset- Based Finance, Reinsurance Solutions, etc.

EXHIBIT 3: The U.S. Currently Invests Less in Transportation Infrastructure Than Other Developed Countries and China. We See This Changing in the Coming Years

EXHIBIT 4: $3.7 Trillion Per Year of Investment in Economic Infrastructure Is Needed Through 2035 to Keep Pace With Expected GDP Growth

Importantly, despite all the growth in demand for private capital, the industry’s size has not kept up with growth in other asset classes. Said differently, if current trends continue, then demand for private assets should actually increase relative to trend. One can see this in Exhibits 5 and 6, which show that private capital as a collective ‘asset class’ is dwarfed by the size of both global financial assets and global equity markets, especially since 2020.

EXHIBIT 5: Invested Private Equity Capital Still Looks Modest Relative to Its Total Addressable Market

Buyouts Remaining Value as a Share of Private Business and Equities, %

EXHIBIT 6: Private Assets Under Management Represent Only About Two Percent of Global Financial Assets

Private Capital Under Management as a % of Global Financial Assets

2. The performance benefit of the private markets’ illiquidity premium helps long-term savers save.

While the Private Alternatives industry requires patient capital, it generally has been rewarded by some form of ‘illiquidity premium,’ or excess return relative to corresponding public benchmarks. One can see this in Exhibit 7. This premium or value has traditionally been created by thoughtful asset selection, operational improvement, and timing of entry and exit when compared to public markets. Given that many countries around the world are reporting a savings shortage for their retirees, we believe the need for excess returns created by private capital from the illiquidity premium will likely go up, not down. Indeed, low birth rates, stagnant working-age populations, and increasing life expectancies have put pressure on global pensions and personal savings and created retirement insecurity for many. Consistent with this view, a recent World Economic Forum analysis suggests that the current global retirement savings gap is US$70 trillion; more importantly, it is expected to increase to US$400 trillion by 2050. The U.S. represents fully 40% of the total gap, implying a $28 trillion¹ savings shortfall.

EXHIBIT 7: Strong Performance From Both Public and Especially Private Asset Classes Will Be Needed to Narrow the Growing Savings Gap

Last 10 Years Net Return by Asset Class, Thru 3Q23, %

EXHIBIT 8: The Global Retirement Savings Gap Is Expected to Reach $400 Trillion by 2050

Retirement Savings Gap, US$ Trillions

3. Private investments provide diversification benefits, especially during what we forecast to be a rapid change in traditional asset allocation.

Beyond the strong performance, investors have also sought Private Alternatives because they often provide favorable correlations with other, more traditional asset classes. One can see this in Exhibit 11. This attribute has become even more critical as we have transitioned from a low-growth, low-inflation environment to one of higher GDP and inflation. As we have written extensively, we believe we have entered a Regime Change for asset allocation (Exhibit 10). As a result, most CIOs and individual investors with whom we speak express the need for ‘all-weather portfolios‘. Our discussions with many CIOs, particularly in the pension, high net worth, and endowment communities, suggest that there needs to be a greater emphasis on earning alpha from asset allocation, rather than just reliance on security and manager selection alone. Indeed, given heightened geopolitical tensions and unorthodox monetary policy, these allocators are looking for portfolio resiliency and diversification rather than optimizing for the last 10 basis points on the efficient frontier curve. Importantly, our view at KKR remains that more diversification across asset classes and less dependence on global sovereign bonds is warranted, particularly as the traditional relationship between stocks and bonds could be changing from negative to neutral and/or positive. If so, this new reality has substantial implications for the typical 60/40 portfolio, we believe. 

EXHIBIT 9: We Think the Era of Negative Rates has Ended. This Reality Has Important Implications for Both Government Spending and Asset Allocation

Global Negative Yielding Debt, US$ Trillions

EXHIBIT 10: Despite Inflation Falling on a Cyclical Basis, We Continue to Think We Have Entered Into a Regime Change for Asset Allocation

U.S. Stock-Bond Correlation and U.S. CPI, %

EXHIBIT 11: CIOs Are Increasingly Focused on the Benefits of Diversification Amidst What We Believe Is a Regime Change for Asset Allocation

Yet, even when we talk to investors who tend to traffic in the private side of the market, many allocators still think about Alternatives more generically, as one asset class with similar attributes. Therein lies an opportunity to learn more and go one level deeper in our view. Indeed, as we detail in this paper, our firm belief at KKR is that each asset class is a separate and distinct component of the Private Alternatives universe, providing unique performance and diversification benefits to portfolios that warrant investor attention.

What are we hoping to accomplish? Our goal in writing this paper is to achieve the following:

• Reflect on the latest developments and trends for Private Alternatives. As detailed below, we still see significant opportunities across Private Equity, Infrastructure, Real Estate, and Private Credit. Importantly, there is a growing demand for private investments to solve a range of problems, including too much government debt, deconsolidation of the corporate sector, deleveraging in critical markets such as Real Estate, and increasing demand for retirement security for aging populations.
• Shed light on the different return, risk, and diversification characteristics of the leading Private Alternatives strategies and the role each could play in a well-balanced portfolio. In our view, too many sweeping generalizations have become normalized across the Private Alternatives industry. For example, including Private Equity in a diversified portfolio has vastly different benefits (and return/volatility profiles) than adding Private Credit. We believe that our research in this area, especially around portfolio construction, is particularly important for some of the newer growth segments of the market, including the individual investor, sovereign wealth funds, and insurance companies.
• Surface potential risks that could affect the Private Alternatives asset classes, and as such, where we think investors need to pay additional attention. Like marriage, investing in Alternatives is not something to be entered into lightly. Finding the right partner to help properly extract the entire value of the illiquidity premium is paramount, as the range of outcomes between the top and bottom quartile is great (Exhibit 103). Moreover, essential portfolio construction tools such as linear deployment, liquidity management, understanding concentration/exposure, and leverage are all prerequisites that an investor must consider. Simply stated, with Alternatives an investor is relinquishing some form of liquidity for a potentially higher return in the future. As a result, we think investors need to be thoughtful in determining their definitions of good value for the fees paid. Finally, regulatory risks and oversight should remain top of mind as this industry continues to grow and evolve. See Section II for details.

Looking at the big picture, we believe that we are at an inflection point in the Alternatives industry. Indeed, it reminds us of what happened when investors were clamoring for better returns in the 1990s and moved their capital out of more traditional bank trust departments towards more performance-based, independent money managers, many of whom became large mutual fund providers to the 401(k)s of today. It was – without question – a time of rapid change in the investment management industry.

In today’s world, we see such an inflection point ahead for both money managers and allocators of capital, particularly regarding longer-term private investment vehicles geared to the retirement savings market. Specifically, as private investments become more transparent and accessible, we think demand will only increase, as the asset classes can be important tools to help close the gap in retirement savings shortfalls (Exhibit 8). Moreover, this increasing need for better returns is occurring at a time when most developed market governments are not in a position to actually pay benefits to retirees through internal free cash flow.

There are other forces at work, too, that we believe will catalyze the change we are forecasting. For example, we think that the onset and fallout from COVID, including the huge swings that we saw in central bank policy along the way, served as an important accelerant in this journey. One simply needs to look at the traditional insurance industry, which allocated more towards Alternatives when the Fed and its peers suppressed rates to stimulate growth at the expense of existing savers. Interestingly, though, despite the 21 Fed hikes that followed COVID (and the subsequent surge in interest rates), insurers did not return to their traditional, pre-pandemic asset allocation. Rather, as one can see in Exhibit 12, insurers’ allocations to non-traditional assets have stayed elevated over the past two years (declining by only about three percent and still about double where they were in 2017). The reality is that more and more CIOs understand the longer-term benefits that private capital can provide.

EXHIBIT 12: Unconventional Monetary Policy Accelerated an Existing Rotation Towards Alternatives, But That Trend Has Not Reversed as Rates Increased

KKR 2024 Insurance Survey: Alternative Allocation and Liability Spread, %

EXHIBIT 13: With Big Deficits and More Geopolitical Shocks, We Think That There Is a Need to Reconsider Whether One Needs More Real Assets in a Portfolio

20 Year Average Annual Returns and Volatility of Real Assets and 60/40 Portfolios, %

Importantly, though, it is more than just insurers. Family offices and individual investors are also now increasingly embracing the return and diversification benefits provided by many parts of the Private Alternatives industry. Strong returns, reduced volatility to better combat public market turbulence, and access to more thematic opportunities also contribute to the sector’s attractiveness. For example, in many emerging markets, public indexes don’t actually capture the benefits of rising GDP-per-capita. Nowhere is this more on display than in Indonesia, which – despite having almost 70 million millennials and a GDP-per-capita of nearly US$ 5000 – offers a public market index comprised of nearly 60% local banks and zero technology companies. One can see this in Exhibit 15.

So, our bottom line is that we are enthusiastic about what lies ahead for the Alternatives industry. However, we also fully acknowledge that this storyline will take many twists and turns, as what is needed for one segment of the market may be different for another segment of capital allocators. Moreover, as this journey unfolds, we are increasingly of the mindset that not all private investment vehicles are made equally; sourcing, operational improvement capabilities, and portfolio construction tools, especially around pacing, will increasingly make a difference, especially as more capital flows into this industry. Consistency of performance throughout cycles will matter more, too, as the illiquid nature of the investment requires a sufficient private market return premium above public markets for what is often a 5-10 year investment. This duration point is especially true for taxable investors who have to pay capital gains tax once an investment is harvested. This reality differs meaningfully from public markets investors, who can often adopt a buy-and-hold strategy to offset capital gains.

EXHIBIT 14: Individual Investors Increasingly See Alternatives as a Resource to Improve Long-Term Returns

Higher Net Worth Individuals Allocation to Alternatives, %

EXHIBIT 15: Like Most Public Market Indices, Indonesia’s Equity Market Does Not Provide Direct Ways to Play the Rising GDP-per-Capital Story

Sector Weights, MSCI Indonesia, %

Hence, as we peer around the corner today on what tomorrow might look like, we believe the Alternatives industry must become a learning institution both in aggregate and at the product level. Don Williams, the country singer, captured our thinking in his famous quote that “The road of life twists and turns and no two directions are ever the same. Yet our lessons come from the journey, not the destination.”

Acknowledgements
Saleena Goel, David McNellis, Racim Allouani, Paula Campbell Roberts, Rebecca Ramsey, Brian Leung, Rachel Li, Thibaud Monmirel, Yifan Zhao, Coco Qu, Patrycja Koszykowska, Ezra Max, Miguel Montoya, Patrick Holt, Koontze Jang, Jackson Battey, Alexandre Caduc

¹ https://cri.georgetown.edu/closing-the-global-retirement-savings-gap-a-tale-of-two-numbers/