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Advisors may want to help clients take advantage of private equity investments for a variety of reasons, including the potential to enhance a portfolio’s return, manage risk, and improve diversification. Indeed, historical data has shown that expanding a traditional 60/40 portfolio to include an allocation to private equity may help build portfolio resiliency, adding a new source of diversification and potentially uncorrelated returns.
Yet for clients with the appropriate risk and liquidity profiles, advisors may wonder how to best implement a private equity allocation. How can they determine, for example, the appropriate percentage allocation and which part of an existing portfolio it should replace? Without understanding the role private equity can play and following a thoughtful process, it can be challenging for advisors to determine the most effective way to implement private equity alongside a client’s other investments.
Why allocate to private equity?
Investors and their advisors have become more open to allocations to private investments in recent years as they seek improved risk-adjusted returns and diversification benefits. Today, given the growing availability of low-minimum investment options, more investors have access to these strategies, once reserved for only the largest institutional investors.
While past performance is not a guarantee of future results, of course, historical data has consistently shown that adding an allocation to private equity investments can potentially help increase a portfolio’s Sharpe ratio. As a reminder, the Sharpe ratio is a measure of risk-adjusted excess return -- it measures the extent to which an investor has been rewarded for the level of risk they have taken in their investment. Further, the diversification benefits of private equity can potentially help client portfolios become more resilient in periods of market distress than portfolios invested solely in public securities.
Given these advantages, advisors may want to consider the role private equity might play in a client’s portfolio and how it might help the client achieve specific goals, such as enhancing returns, capital appreciation, and diversification.
Building an additive and effective allocation to private equity
Advisors should consider these key steps in constructing, implementing, and maintaining a private equity position within a well-diversified portfolio.
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Develop an investment plan. Start by considering the client’s investment goals, needs, and preferences. This includes liquidity needs, risk tolerance, income needs, and potential tax impacts. Especially important to focus on are the client’s liquidity needs and time horizon, as private market investments are by definition less liquid than public market investments. Consider how an allocation to private equity may align with the client’s goals and needs. Then develop targets for performance and diversification.
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Determine a target allocation. Next, determine a broad allocation target for private equity investments based on the client’s portfolio objectives. Determining how much to allocate largely depends on the client’s objectives and risk profile. Conduct a portfolio analysis to determine how the target allocation will be achieved and maintained.
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Select an investment structure. There are different fund structures available to access private equity including interval funds, tender funds, nontraded closed-end funds, and private placements. Each type of investment structure has pros and cons, so advisors should align the right type of investment structure with the client’s liquidity needs, time horizon, investment restrictions, and risk tolerance.
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Research managers. Manager selection is critical because there is a high degree of performance dispersion among private equity investments. Key elements in the evaluation process include performance record, the strength and experience of the investment team, and the managers’ risk management framework, such as how diversified the fund is across sectors, geographies, and vintage years. Another important consideration is which sub asset classes an investment and its manager focus on -- buyout strategies, growth equity, or venture capital -- as each provides differing risk/return profiles based on where they invest in a company’s economic life cycle.
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Implement the new allocation. Once the investment opportunity is identified, advisors may want to consider market conditions, fundamental valuations, and the existing portfolio’s attributes to determine the optimal timing of a private equity allocation.
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Monitor and adjust regularly. Advisors will want to monitor the private equity allocation to confirm that these assets remain invested as intended. This includes rebalancing the portfolio as needed to maintain the specific target allocation. Additional commitments may be required to maintain the private equity percentage relative to allocation targets.
Effective implementation can enhance portfolio outcomes
By thoughtfully constructing a portfolio to include private equity, advisors can help clients increase diversification, possibly lower volatility, and potentially tap into the growth potential nonpublic investments offer. Yet private equity investments can be complex and include a diverse range of investment structures to consider. Determining how to fund an allocation to private equity effectively requires a thoughtful and systematic approach. Partnering with an experienced investment firm can help advisors navigate the decision process successfully.
Michael Bell is the CEO of Meketa Capital.
This document is for general information and educational purposes only, and must not be considered investment advice or a recommendation that the reader is to engage in, or refrain from taking, a particular investment-related course of action. Any such advice or recommendation must be tailored to your situation and objectives. You should consult all available information, investment, legal, tax, and accounting professionals, before making or executing any investment strategy. You must exercise your own independent judgment when making any investment decision.
All information contained in this document is provided “as is,” without any representations or warranties of any kind. We disclaim all express and implied warranties including those with respect to accuracy, completeness, timeliness, or fitness for a particular purpose. We assume no responsibility for any losses, whether direct, indirect, special, or consequential, which arise out of the use of this article. All investments involve risk. There can be no guarantee that the strategies, tactics, and methods discussed in this document will be successful.
Data contained in this document may be obtained from a variety of sources and may be subject to change. We disclaim any and all liability for such data, including without limitation, any express or implied representations or warranties for information or errors contained in, or omissions from, the information. We shall not be liable for any loss or liability suffered by you resulting from the provision to you of such data or your use or reliance in any way thereon.
Nothing in this document should be interpreted to state or imply that past results are an indication of future performance. Investing involves substantial risk. It is highly unlikely that the past will repeat itself. Selecting an advisor, fund, or strategy based solely on past returns is a poor investment strategy. Past performance does not guarantee future results.
Meketa Capital is an investment advisor registered with the U.S. Securities and Exchange Commission.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.