The Case for a Private Equity Allocation

Kevin Ward, Advisor

Private equity’s popularity has soared over the past couple of decades among institutional and qualified-high-net-worth investors—perhaps a response to mutual and exchange-traded funds’ massive rise in the 1980s and 1990s. But popularity alone needn’t dictate a personal allocation to private equity. Though some investors may benefit from some private equity exposure, it’s important to first explore what it is and how to think about it in the context of a personal portfolio strategy. Our companion piece explores the “why” in more depth.

An Alternative Investment

Private equity is among the investment vehicles considered alternative investments, including private credit, real estate, real assets, and others. Private equity’s defining feature is in its name—private—which differentiates it from public market investments in typical vehicles like stocks and bonds. Investors in a private equity fund (referred to as limited partners) provide capital to companies that aren’t publicly traded—whether they’re in the early fundraising phase, are more mature and possibly approaching a public listing, or are distressed and seeking to restructure.

Investors can make private equity investments directly (i.e., in a single, private company); via a primary investment fund, in which investors pool capital in a vehicle directed by a professional investment manager, referred to as the general partner; or via a fund of funds, in which investors similarly pool capital but invest it across multiple managers with differing strategies. However facilitated—whether directly or via a fund of funds—most private equity investments are highly illiquid with specific capital lock-up periods. And for a good reason: Private equity funds generally aim to invest in long-term initiatives and operations at companies the private equity manager believes will generate attractive growth. Critical to this investing approach is allowing sufficient time for investments to bear the anticipated fruit.

Three Phases

Private equity funds generally operate in three phases: capital commitment, investment, and distribution. During the capital commitment phase, investors agree to provide a set amount of capital for a set period, typically three to five years. The general partners will issue capital calls as they identify companies they’d like to invest in. As the fund exits investments, it will typically distribute capital to the limited partners according to the distribution waterfall. The general partners are often compensated via a management fee (typically around 2% annually of the fund’s committed capital) and a performance fee, also referred to as carried interest (often 20% of investment gains, assuming performance reaches a specified hurdle rate which could be either a set percentage return or defined by a benchmark).

Long-Term Nature

Given private equity investments’ long-term nature, the private equity fund manager’s expertise and track record directly contribute to the fund’s likelihood of long-term success. Private fund managers don’t invest and then sit back to watch the company progress—or not. On the contrary, private fund managers are typically directly involved in portfolio companies in multiple ways—e.g., ensuring they’re operating efficiently, helping them navigate complex regulatory environments (depending on their industry), making needed connections to help them advance their initiatives, and others. In this sense, private fund managers become important and trusted business partners to their portfolio companies, playing a meaningful role in shaping their growth prospects. In so doing, the aim is naturally to increase the initial investment’s value.

As we’ve noted, this process can take years to play out—which is why many private funds require years’-long capital lock-ups and are highly illiquid (and non-transferable). These are also among the reasons private equity investments are restricted to institutional and accredited investors or qualified purchasers, who are typically capable of tying up capital for extended periods and who can also sustain the potential losses that can accompany private equity investments (as they can any investment, none of which are entirely risk-free).

How do I think about private equity in the context of a personal portfolio?

First, a private equity allocation can provide an important source of diversification. Relative to the public markets, the private market is enormous: Whereas there are roughly 6,000 publicly traded companies in the US, there are over 220,000 companies with more than $10 million in annual revenue (data from NAICS as of February 2021 and MarketWatch as of October 2020). Another way to think about the opportunity set’s magnitude is by comparing the size of the US economy, which has roughly doubled since 1996, to the number of publicly traded companies, which has fallen over the same period by 46%. And this data just refers to the US—factoring in the rest of the world increases the opportunity set yet again and contributes to its diversification across geographies and sectors.

Broader markets imply greater return dispersion—a bigger pool of potential investments will often offer both higher highs and lower lows—and the potential for returns is relatively uncorrelated to those offered by public markets. Done thoughtfully and effectively, investing in some asset classes that zig while others zag over a sufficiently long time horizon should have the potential to deliver superior long-term results with lower overall volatility. It’s Harry Markowitz’s well-known Modern Portfolio Theory broadened from public markets to include alternative asset classes, like private equity.

However, given the risks—illiquidity, market risk, etc.—private equity may not be a fit for every investor. Hence why investments are restricted to institutional, accredited investors (for whom the primary threshold is income-related) or qualified purchasers (the primary threshold for whom is asset-related) and why the minimum investments tend to be high. Even for those for whom private equity is a good fit and who are qualified, the portfolio percentage allocated to private equity is a major consideration. That said, there are alternative methods of accessing alternative investments, including via vehicles such as interval funds, which are a variation of a closed-end mutual fund that provides periodic (hence “interval”) liquidity to investors by repurchasing shares at the current Net Asset Value.

All told, a private equity allocation can play an important role in an overall portfolio—though it shouldn’t be made without meaningful due diligence and thoughtful consideration of the percentage allocated. Time horizon, investment return goals, market risk, and illiquidity tolerance are considerations before locking up your capital for a significant period. In our companion piece, we will delve into why a private equity allocation may be worthwhile to the right investors and the determinative role a financial advisor can play in helping at least investigate, if not mitigate, some of the opacity often associated with private equity investments.

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© 2022 Moneta Group Investment Advisors, LLC. All rights reserved. The information contained herein is for informational purposes only, is not intended to be comprehensive or exclusive, and is based on materials deemed reliable, but the accuracy of which has not been verified. Examples contained herein are for illustrative purposes only based on generic assumptions. Given the dynamic nature of the subject matter and the environment in which this communication was written, the information and opinions contained herein are subject to change. This is not an offer to sell or buy securities, nor does it represent any specific recommendation. You should consult with an appropriately credentialed professional before making any financial, investment, tax or legal decision. Past performance is not indicative of future returns. All investments are subject to a risk of loss. Diversification and strategic asset allocation do not assure profit or protect against loss in declining markets. These materials do not take into consideration your personal circumstances, financial or otherwise.

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