Portfolio Construction: Strategies for Allocating 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.