Last year should serve as a stark reminder to investors of the havoc extreme volatility can wreak on a portfolio while illuminating the increasing challenge of achieving true diversification. As an aging bull market gives way to increasing headwinds, investors with substantial assets may be facing a prolonged period of lower growth and more uncertainty with the realization that traditional investments alone won’t be enough to achieve their investment goals.
An Alternative Investment: Private Equity
True diversification has become more elusive for business owners. It wasn’t too long ago when investors were able to diversify their equity portfolio through a simple allocation of equities, bonds, REITs or commodities, with many having correlations below 0.5 relative to the S&P 500. A growing consensus among market analysts is that equity returns over the next several years may be constrained by a combination of slowing economic growth and relatively high equity valuations. Bonds, once the traditional counter to equity headwinds, have been generating negative returns for portfolios and are becoming less attractive with each uptick in interest rates.
Many investors with longer investment horizons and less need for liquidity have allocated a portion of their portfolios to alternative investments such as private equity1. However, most investors have continued 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.
Private Equity Investing Defined
Private equity is an investment strategy in which capital is raised from investors to acquire equity-ownership in companies that are not publicly traded. Most fund strategies involve acquiring ownership in a small number of companies that have a high potential for value creation selected from among thousands in certain categories (i.e., region, sector, market cap).
Because private equity managers are willing to give up liquidity to achieve higher returns over a longer-term holding period, they aim to capitalize on the illiquidity premium available in the market. Liquidity typically comes in the form of a return of capital from the sale of companies in the portfolio. The typical holding period for a company is five to seven years, depending on the exit strategy, which might be a public offering, sale to another company, or sale to another private equity firm.
Private Equity vs Public Equity
Over the past 25 years, the number of publicly listed US companies has been nearly cut in half from a peak of over 8,000 in 1996. The decline in the number of public companies is being driven not only by private equity acquisitions but also the lack of initial public offerings (IPO). Private equity firms are choosing to retain ownership in some of their companies rather than sell them through traditional channels. Even so, US public equity markets are still substantially larger than the private equity and venture capital markets. There is still room for more to be done in the private investment arena.
Why Private Equity?
For investors with substantial assets1, 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.
- 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 use 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 typical allocation can range from 10% to 25% of an overall portfolio.
About Venturi Private Wealth
Venturi’s core mission is to help organize, plan, and manage all aspects of wealth for families and entrepreneurs with substantial assets and complex business and personal financial lives—so you can focus on doing the things that matter most to you. We manage more than $1 billion in assets, a significant portion in house, often eliminating additional layers of management fees. Founded in Austin, Texas, Venturi incorporates the city’s entrepreneurial energy into everything we do for our clients.
Partnering with the right people to help manage your financial livelihood is not a small step. The issues are complex. You may want to use an advisory firm to help guide you through the process.
1Private equity investments are available to qualified clients only (a minimum of $2.1 million in net worth, not including primary residence, or $1 million of assets under management with an adviser).