High valuations do not change the vital role that private equity can play in your portfolio.1
In recent years, investors have turned in record numbers to private equity to enhance their portfolios’ return potential. But higher valuations stemming from this influx of money, coupled with concerns that the current economic cycle could end soon, are causing many investors to question the benefits of private equity going forward.
To explore these concerns, Wealth asked Katie Nixon, CIO of Northern Trust Wealth Management, to provide perspective on this increasingly popular – but often still less familiar – asset class.
Wealth: Private equity is a staple building block in the portfolios Northern Trust builds for qualified investors. Why?
Nixon: When building resilient portfolios for our clients, we consider all available sources of risk, return and diversification. From there, we perform robust research at the asset class level to understand the true sources of risk that drive return, and to focus on only accepting risk that is well compensated. Through this lens, private equity fits the bill and is particularly well-suited to help clients achieve longer-term goals. This is true for a few reasons:
First, the asset class offers enhanced return potential. Research on long-term performance demonstrates that the average private equity fund has outperformed public equity. This is largely attributed to what is referred to as the illiquidity premium – the extra compensation demanded by investors to invest in an illiquid asset.
Second, the asset class has potential diversification benefits. I say potential because the diversification benefits of private equity are driven by manager skill, or “alpha”. Alpha enhances broader portfolio diversification, because it is a unique source of return that is uncorrelated to other sources of return. But access to skillful managers is key.
Third, private equity has the added, less obvious benefit of helping investors avoid common behavioral biases. Given the lack of liquidity, selling private equity positions during market stress is simply not an option. This forces investors to stick with their long-term strategy.
Wealth: How much should investors allocate to private equity? What is the right portfolio percentage?
Nixon: The right allocation depends on a number of variables unique to each client, but we believe we have a good process for identifying it.
Our asset allocation process starts by grouping asset classes into two uncorrelated buckets of “super” asset classes, which we call the Risk Control and Risk Asset portfolios. Then we determine the optimal mix of asset classes underneath these two categories, including private equity within the Risk Asset portfolio.
From there, we determine the actual size of individual investors’ allocations by finding the optimal mix of Risk Asset and Risk Control portfolios that align with their unique objectives. For clients in our Goals-Driven framework, this mix reflects the time horizon of their goals and the degree of confidence they desire for attaining each goal. In practice, this results in a wide range of allocations to private equity and other alternative investments – anywhere from roughly 5% to 40% that is largely a function of each client’s time horizon and liquidity preference.
One important thing to note about private equity is the ongoing commitment it requires. Once you determine your target allocation, it can be difficult to achieve and maintain, because you must continually make new investments to offset distributions from maturing funds. We have found that a good rule of thumb is that you need to commit half your target allocation every other year.
A “One and Done” Approach Will Not Achieve Your Target3
Wealth: What about the underlying strategies? How do you identify the best investments for your clients’ portfolios?
Nixon: Ultimately, the success of private equity investments hinges on the skill of the manager and their ability to deliver sustainable, long-term returns above and beyond the broader illiquidity premium offered by the asset class. So that is where we focus.
For our ArcLine Alternatives platform, which we launched in 2018, we look for unique and differentiating strategies and for managers with strong track records who have produced alpha. Interestingly, unlike with public equity, most private equity managers who have demonstrated top quartile performance tend to show persistent top performance over time.
Private equity strategies focused on smaller- and medium-sized private businesses, where there are less money chasing opportunities, can also offer compelling long-term value. Our affiliate, 50 South Capital, focuses on this space, with a similar emphasis on manager skill.
Wealth: News headlines have recently reflected growing concerns about high private equity valuations. Should investors be concerned?
Nixon: There is no doubt that valuations are high. Fundraising has been prolific, with non-traditional investors, such as hedge funds and even mutual funds, increasingly participating in the private equity market. Plus, companies are staying private longer in recent years, receiving successive rounds of financing at valuations closer and closer to public markets, further contributing to elevated valuations.
What this means is that investors need to be more discerning and lower their return expectations. What this doesn’t mean is that they should avoid the asset class altogether. We believe that even with lower return potential, well-selected private equity investments will continue to offer enhanced return potential [over public equity] as well as portfolio diversification benefits.
Wealth: What are three top takeaways for investors relatively new to the asset class? What do they need to know?
Nixon: One, private equity is a fundamental component of globally diversified risk asset portfolios – not a fringe asset class. By offering alpha – it acts as both a return enhancer and portfolio diversifier and is therefore instrumental in helping qualified investors achieve their goals. Of course, investors need to be aware and comfortable with its risks and illiquidity. But in most instances, the benefits of the asset class outweigh these hurdles.
Two, private equity requires dedication. This includes committing to having your money tied up in an illiquid investment as well continually making new investments to maintain your target allocation. It’s important to understand and embrace this commitment upfront.
Third, picking the right strategies is key. Not all private equity managers consistently produce alpha, and poor performance tends to persist. When evaluating performance, investors need the expertise and tools to separate manager skill from other more commonly available sources of return. Our process focuses on doing just that.
The information contained herein is for informational and educational purposes only. Past performance is not indicative of or a guarantee of future results, which will fluctuate as market and economic conditions change. Private assets are illiquid and are not suitable for all investors, and transferability may be limited or even prohibited.
The Private Equity benchmark is a horizon calculation based on data compiled from 4,863 funds: 1,807 US venture capital funds, including fully liquidated partnerships, formed between 1981 and 2018, and 1,481 US private equity funds (buyout, growth equity, private equity energy and subordinated capital funds) and 1,575 Ex US private equity & venture capital funds, including fully liquidated partnerships, formed between 1986 and 2018. Private Equity indices are pooled horizon internal rate of return (IRR) calculations, net of fees, expenses, and carried interest. Data as of 9/30/18. Sources: Cambridge Associates LLC, Barclays, Dow Jones Indexes, Frank Russell Company, MSCI Inc., MSCI Inc., Standard & Poor's and Thomson Reuters Datastream. MSCI data provided "as is" without any express or implied warranties. Notes: Total returns for MSCI Emerging Markets indices are gross of dividend taxes. Total returns for MSCI Developed Markets indices are net of dividend taxes. Data as of 9/30/18. Past performance is not indicative or a guarantee of future results.
Source: Northern Trust Research The information contained herein is for information and educational purposes only and does not constitute a recommendation for any investment strategy and is not intended as investment advice and is based on hypothetical returns. Hypothetical portfolio data contained herein does not represent the results of an actual investment portfolio. If the hypothetical portfolio would have been an actual portfolio it would have been subject to market and economic conditions that could have materially impacted performance and the results illustrated above.