How Should You Implement Private Markets in Your Portfolio?

Private markets give investors a broader and deeper opportunity set as compared to traditional investments in public markets. This is due in part to the number of publicly traded companies shrinking in recent years. Private equity funding, such as in real estate, venture capital, and hedge funds, can improve portfolio performance over the long term as compared to public markets.

What do investors need to know before investing in private equity? When choosing private markets, investors should consider:

  • The dynamics of private markets, both fundamental and administrative, result in periods of capital drawdown and capital return for committed investments. Achieving and maintaining target allocations requires long-term planning and dedicated annual commitments.

  •  Allocation methods to private markets include fund of funds, direct investments, co-investments or a combination of the three.

  •  Return dispersion creates the need for diversification within the portfolio, allocating across vintages, sectors, geographies and strategies.

Private Market Allocations Increase

Dedicated allocations to private markets have continued to increase among investors and have been a key contributor to outperformance by institutions and individuals. The 2018 NACUBO-TIAA Study of Endowments indicates that institutions over $1 billion outperformed the average endowment over the past 10 years.

Unsurprisingly, these institutions also had the largest allocations to private markets. The long-term benefits go beyond just returns of the asset class. Investing in private markets permit investors to access a broader and more fragmented opportunity set not investable by public markets managers.

Also different from public markets is the investment structure, which is “closed-end” rather than “open-ended.” The public markets investment structure does not allow simple “buy” and “sell” transactions.

While the administrative and planning side may sound daunting, there are multiple avenues to create successful private markets allocations for any size portfolio. These avenues include the ability to diversify across asset classes, geographies, and sectors, maintaining the diversification principles established as beneficial to positive, long-term outcomes.

Incorporating private markets into the portfolio enhances diversification and provides additional alpha. The opportunity set for private equity investment managers is significantly wider than that for managers in the public markets.

There are more than 180,000 businesses in the U.S. that generate over $10 million dollars in revenue annually while Bloomberg cites approximately 3,600 companies listed on U.S. stock exchanges. Investors excluding private equity from their portfolio are ignoring the vast majority of the opportunity set.

Fi3 Private Markets Portfolio Chart_1.jpg

Additionally, the number of publicly traded companies has continued to shrink over the years, peaking at over 7,600 in 1997. The multi-decade decline coincides with the rise in availability of private capital, among other contributing factors.

Today, companies are taking advantage of the additional avenues available in order to raise capital. If recent trends persist, the avenues will remain open and alternative sources of capital will continue to grow. 

Unique Investment Structure

 One hurdle for many investors is the practical implementation of private markets given the unique investment structure. Private markets funds are closed-end, meaning they have a predetermined life.

Rather than “buying” — as investors are able to do with stocks, bonds, or “open-ended” ’40 act funds — investors “commit” the amount of capital they would like to invest. This capital is then “called” by the manager over the investment period.

In similar fashion, rather than “selling,” the investment manager returns capital to investors following the disposition of portfolio companies.

In all, a private equity investment vehicle can last for 12-plus years. The cash flow dynamics between the investment period, when capital is called from investors, and the harvest period, when capital is returned to investors, creates what is known as the “j-curve.” The graphic below demonstrates what this looks like over the life of a fund.

Fi3 Private Markets J Curve Chart.jpg

The j-curve is characterized by negative returns in the early years with capital being called, management fees charged and new investments marked at cost. In the harvest period, as the fund matures, investments are realized or appraised at updated values and the return metrics normalize.

Each fund’s curve will look slightly different as a result of when managers identify companies they want to purchase and when they later realize holdings. The earlier cash flow is returned to investors, the shorter the j-curve. Funds that are slower to return capital end up with a longer j-curve.

The cash flow dynamic of the structure creates a challenge for portfolio implementation. How do investors maintain allocations when they cannot control when their capital is invested? Planning is the key.

First, allocations to private markets are strategic, not tactical. This is a dedicated allocation within a portfolio, just like that of stocks or bonds. Second, to achieve the target allocation, a certain amount of capital must be committed annually and continue to be committed over time to maintain allocations.

By setting a plan and framework around how to commit capital, investors can achieve long-term strategic allocations to private markets. While cash flow modeling can help establish a plan, frequent revisiting is paramount to ensure targets will be reached. From a starting point of no allocation, it can take between four and six years to achieve the desired allocation.

The length of time required to reach a target allocation is due to the need for vintage year diversification. The risk of overloading any particular year will have a material impact on the long-term outcome of the private markets portfolio as well as your broader portfolio.

Consider two investors who initiated private equity allocations in 2003 and 2006, respectively. They both over-commit early to reach their target allocation sooner. The investor who started in 2003 has the benefit of returning approximately 25% while the investor who started in 2006 returns roughly 7%.

On the race to their target allocation, each investor made an unintentional bet that led to materially different and, most importantly, unpredictable outcomes that the portfolio was subject to for a decade or more.

The chart below highlights the differences in internal rate of return (“IRR”) that can occur from one year to the next. Consistency and patience are important when building an allocation. It’s likely the ownership period will last for a full market cycle, and continuing to invest across that market cycle is important to long-term outcomes. 

Fi3 Private Markets Vintage Year Dispersion by Asset Class_1.jpg

Remember to Diversify

Also critical is diversification by strategy type as well as sector. Traditional buyout, growth equity, venture capital and distressed or special situations funds will perform differently throughout the market cycle. By investing in high-quality funds in each area, investors will realize better risk-adjusted performance across market cycles while still generating significant alpha.

Technology is a large component of the private markets due to the level of growth it has historically achieved. Although this is a key sector for allocations, it is important to diversify just as it is in public markets and portfolios broadly.

The preferred method for access is to create a diversified portfolio of direct fund investments. The green line in the chart below highlights this type of investment.

Fi3 Private Markets Direct Investment Funds_1.jpg

Direct investments into funds allows investors to take a targeted approach to a select group of managers and have complete discretion into how the underlying portfolio is organized. More importantly, through this approach, investors can create the level of diversification we described above. While this takes a meaningful commitment to the asset class, it is not solely for the largest subset of investors.

A fund of funds approach, signified by the purple line, can also be utilized in order to gain diversification by managers and sectors. This comes with an extra layer of fees, which can lower overall returns. Lastly, direct co-investments (dark blue line) can complement either direct investments or fund of funds investments. These are investments made directly into a company alongside a private equity manager.

With focused planning and a thoughtfully driven approach, investors can achieve a private markets allocation that adds meaningful return and diversification from other asset classes. A combination of direct investments and investments in fund of funds can create a desirable level of diversification within private markets while maintaining the characteristics that lead this asset class to creating alpha over long time horizons.

Do you have questions about private markets allocations in your portfolio? Contact an advisor at Fi3 today.