The experience of the past few years has shown that the perceived difference may be a misconception, with the risk profile of public and private equity proving to be inherently similar. Faced with this uncomfortable truth, investors must go back to first principles if they are really to understand how private equity can fit into their portfolio.
Research your managers
Private equity certainly offers investors the possibility of outperformance. Inherent factors, such as the illiquidity premium, can make the investment more advantageous than traditional financial instruments. But the spread of returns in this ‘asset class’ is very wide and investors wishing to make use of it in their portfolios must be able to consistently identify and get access to the best managers.
Private equity is also seen as a risk diversifier. The impact of the 2008 financial crisis, however, which had a catastrophic impact on many supposedly well protected and well diversified portfolios, highlights this is not automatically the case. Investors who used ‘alternative assets’ as a method of avoiding correlation with public equities saw their portfolios lose value in tandem with the stock markets. The issue wasn’t with the fundamentals of the so called ‘alternatives’, but rather the way that investors were using such investments in their portfolios.
A true diversifier?
Capital Generation Partners’ recent First Principles Diversification research, which analysed 30,000 portfolios, sheds some light on why private equity isn’t an automatic diversifier. The fact is that private equity fund investments employ the same underlying strategies that investors are trying to diversify away from – namely directional bets on equity stakes of one form or another. Without careful planning, a distinct allocation to private equity can therefore leave investors over concentrated. This unnecessary risk can only be avoided by changing their portfolio construction habits – based upon a deeper understanding of the underlying strategies employed by investments.
How to diversify
The more sophisticated approach is to reclassify each asset class as falling into one of three buckets – cash, equities and debt and then to assess whether the strategies employed in each case are directional or arbitrage strategies and then whether they are discretionary or systematic. Following this categorisation leaves a possible 12 different underlying strategies to select. Private equity, for example, can be classed as a directional/discretionary equities investment which is, as it happens, exactly the same profile as an active public equities fund.
An investor that allocated equally to these 12 strategies over the period January 2004 – September 2012 would have received similar returns with significantly lower volatility when compared to both a traditional 60:40 equities:bonds portfolio and an ‘enhanced’ portfolio that includes equities, bonds and ‘alternatives’. Over the period, the First Principles Diversification portfolio would have achieved 4.7% annualised returns with just 5.0% volatility, whereas the traditional portfolio received 4.8% annualised returns, 11.7% volatility and the enhanced portfolio 5.3% annualised return, 12.3% volatility.
It can work
None of this is to say that private equity has no role in the diversified portfolio – on the contrary it is an essential corner-stone of properly diversified and managed portfolios. It is true that there is more modest fundraising across the spectrum and an evolution of fund managers that has led to greater clarity between ‘institutional private equity’ and ‘entrepreneurial private equity’. In truth this is good for the industry. Private equity can be of a benefit to investors, but only if they understand the risks and how to fit such investments into their portfolio.
You can find out more about the Captial Generation Partners report on alternatives as diversifiers here.
