One of the key lessons of the 2018 investment year is that extreme volatility can wreak havoc on investment portfolios, even those that are thought to be relatively safe due to diversification. For some investors, the answer to those problems is to consider alternative investments, such as private equity.
True Diversification Becoming More Elusive
It wasn’t too long ago when investors were able to diversify their equity portfolio through a simple allocation of bonds, REITs or commodities, with most having correlations below 0.5 relative to the S&P 500. However, since the 2008 financial crisis, correlations across these assets have increased, providing less and less of a haven for volatile equity prices.
Bonds, once the traditional anchor to equity headwinds, have been generating negative returns for portfolios and they are becoming more radioactive which each uptick in interest rates. Bond yields and equities have been positively correlated over the last decade, providing investors with a reliable negative correlation between stock and bond prices as a hedge against equity risk. However, more recently, bond yields have been rising while equity prices have been falling, which only increases portfolio volatility.
Private Equity as a Complement to Traditional Strategies
With their longer investment horizons and greater tolerance for liquidity, some institutional investors are allocating a growing portion of their portfolios to alternative investments, such as private equity, to help achieve their target returns. However, financial advisors and individual investors continue to focus their allocations primarily on traditional investments, largely ignoring or avoiding alternative investments. A big reason is simply a lack of awareness of or comfort with private equity strategies or the misconception that they are only available to institutions or ultra-wealthy investors. That seems to be changing as an increasing number of advisors and investors are now looking beyond traditional investments to augment portfolio returns.
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Why Private Equity?
For high net worth investors, the potential advantages of private equity investments include:
- Long-term growth potential. Over an extended period of time, growth and returns in the private market may outperform those in the public market on both a risk-adjusted and absolute basis.
- Attractive valuations. Valuations in the private market may be much more attractive than the public equity market, especially when publicly traded companies become overvalued as they have in recent years.
- Diversification. Factors that drive returns in public equity markets, such as volatility, investor sentiment, quarterly reporting, and seasonality, have little or no effect on the private market, which enhances private equity’s diversification potential.
- Long-term strategic focus. Managed investments in private companies allow for a long-term strategic focus rather than a short-term focus on public market quarterly earnings, creating the opportunity for higher capital appreciation.
- Extensive due diligence. Due to the illiquidity risk, private equity managers conduct extensive due diligence on a company before selecting it for the portfolio.
How Much Should Investors Allocate to Private Equity?
When considering private equity in the context of overall portfolio allocation, it is important for investors to utilize a long-term investment horizon to realize the potential benefits of the strategy. As with any asset allocation, the optimal allocation for private equity should depend on an investor’s specific financial goals, liquidity needs, return goals, and varied time horizons. However, the most important factor investors must consider is their liquidity needs.
For example, a conservative investor nearing retirement may feel the need to have more capital available to meet their cash needs. An investor with a more opportunistic profile and a longer-term horizon may be able to tolerate greater liquidity risk in exchange for higher returns. An ultra-high net worth investor with legacy aspirations may have no liquidity concerns.
The optimum private equity allocation is the one that best aligns with an investor’s investment profile and long-term goals. Depending on one’s liquidity needs, a proper allocation might range from 5% to 30% of an overall portfolio.