Allocating to Private Equity
"Private equity has long been an elusive asset class that garnered a lot of attention – but was out-of-reach for most investors. As private equity has become more mainstream, advisors are being challenged to get up to speed with respect to product innovation1 - and the options available to their clients. The biggest question that I’ve been hearing from advisors is - how to effectively allocate to private equity?"
In this blog, we’ll delve into the asset allocation and portfolio construction considerations of private equity2. Advisors should evaluate the following:
Risk & Return – what are the expectations and assumptions?
Liquidity – are there limitations on how long capital may be locked-up?
Time Horizon – what is the time horizon for the overall portfolio?
Diversification – can you diversify across manager, stage, region, industry & vintage?
Asset Location – what is the appropriate entity to hold the investment?
Target Allocation – what is the appropriate target allocation?
Allocating to private equity, private debt, private real estate, infrastructure and natural resources provides advisors with a way of demonstrating value. With so much of an advisors value proposition being commoditized – robo financial planning and asset allocation – these unique investments allow advisors to add considerable value to investors.
The appeal of private equity has long been the potential for oversized returns and diversification. Private equity managers often make investments in early-stage companies, and reap the benefits as they mature and often going public. They attempt to identify the next Apple, Google, Facebook or Beyond Meat. Because of the private nature of these investments, the underlying companies aren’t subjected to the same short-term volatility of public companies. Please note, private equity volatility is likely understated due to the nature and frequency of valuing securities.
Select Asset Class Returns (1998-2018)
Source: Morningstar Direct, 2019
Of course, private equity represents a broad range of companies at different stages of developments, from early-stage Venture Capital to Growth Capital and Buyouts. VC investing is typically the riskiest investment. Advisors need to consider the stages of development as they allocate to private equity. Diversification across the various stages of development helps spread the risks.
Private equity should typically be thought of as a long-term investment (7-10 years). This is due to the nature in which capital is deployed and the timing for generating returns. The chart below provides an illustration of the various stages of private equity and the corresponding cash flows. During the Investment Period, capital is drawn-down as investment opportunities are being sourced. During the Value Creation stage, private equity managers are providing their expertise to improve operational efficiency. During the Harvest Period, private equity managers exit the underlying investments through a sale or IPO.
Stages of Private Equity
The gold line above illustrates the cash flow, or cash drag, associated with a typical private equity investment. This is often referred to as the “J-Curve” where there is negative draw-down in the early stage of private equity investing and sharp reversal as value is unlocked in the underlying investment.
Product innovation has sought to address some of the structural limitations of the classic private equity structures (i.e., minimums, tax reporting, liquidity and others). Interval and Auction Funds have helped to democratize private equity investing and address some of the structural limitations.
Structural Innovation and Evolution
Source: Tangent Capital
As noted above, there are structural trade-offs that allow for greater flexibility in how advisors allocate to private equity. In fact, it may be prudent to allocate to multiple strategies across multiple structures. For example, while Interval Funds offer greater liquidity and better tax reporting, they will likely experience a significant tax drag and may not have access to the best opportunities.
If investors have the wherewithal, they may be better served with broad-based diversification across private equity. Diversification can broaden the investment opportunities, lower the risk and minimize the cash drag.
"Advisors should consider diversification across manager, stage, industry, region and vintage."
Private equity represents an attractive investment option, especially as product innovative has helped in democratizing this once elusive asset class. There are a number of key asset allocation and portfolio construction considerations for advisors. With new products coming to the market, and established asset managers seizing the opportunities, there is now more research and information available to advisors and investors.
The Investments & Wealth Institute has developed a powerful three-part series, New Ammo for the Affluent: Next Generation Private Securities that explains how to add significant value to your clients’ portfolios and your practice. This series explains in detail the opportunity set in the private security landscape, the major developments in legal and market structures, and a framework for including private investments into clients’ portfolios.
For addition information about Private Equity, please visit https://www.icapitalnetwork.com/category/insights/private-equity/.
Sources:
1 Davidow, Anthony, “Private Equity: Innovation and Evolution”, Investments & Wealth Monitor, November / December 2019
2 Davidow, Anthony, “Alternative Investments: A Goals-Based Framework”, Investments & Wealth Monitor, January / February 2018