2012 Issue 3
Investors can trade illiquidity for greater diversification and the potential to earn higher returns.
Institutional investors face a dilemma: how to enhance yield without taking on an inordinate, or uncompensated, amount of risk. Within the context of a well-diversified portfolio, one way might be to add or increase an allocation to private equity investments. In addition to possibly reducing risk through greater diversification, the asset class also offers the potential to enhance returns because of market inefficiencies that skilled managers can exploit.
Private equity is particularly attractive in the current investment climate. Cash investments offer principal protection, but no discernible return. Fixed-income investments are not yielding much more, with some sovereign bonds actually “earning” investors a negative return. Other than pockets of fixed income that pay investors a premium for taking risk — such as high-yield bonds and emerging market bonds — the “go-to” asset classes for returns today are equity and alternatives. Private equity, however, offers compelling opportunities relative to public equity.
Whether you consider private equity an “alternative” investment or a “relative” of public equities, private equity is brimming with opportunity and can effectively help diversify and ease risk in a large portfolio with a long-term orientation. Private equity opens a whole new universe of investment targets for investors, which by definition (because they are private) are not accessible through public markets. This makes the risk and return drivers different and distinct from other investment options, adding diversification and return opportunities to a portfolio.
There are, however, additional considerations to weigh. For example, private equity might not be suitable for investors unable to dedicate a portion of their portfolio to such an illiquid asset class, where a typical investment often requires a five- to 10-year time horizon.
On the upside, investors in this asset class tend to be well compensated for assuming illiquidity risk. Private equity investors are effectively paid an “illiquidity premium” for making a long-term commitment. This illiquidity premium exists because private equity fund managers and business owners are afforded the time, as a result of a patient investor base, to focus on building long-term value in their companies.
“Investors should exploit the advantage to generate illiquidity premium,” said Andrew C. Smith, CFA, CAIA, chief investment officer, client solutions group, Northern Trust. “Investors should be compensated for tying up that capital, and historically they have been. The critical thing is to be educated about the inherent risks of private equity and to understand how much exposure you should have to private equity relative to your liquidity needs.”
Bob Morgan, managing director of Northern Trust alternatives group, said the illiquidity premium could average between 3% and 5% above the average returns generated by the broad public equity market.
“Investors should be compensated for tying up that capital, and historically they have been. The critical thing is to be educated about the inherent risks of private equity and to understand how much exposure you should have to private equity relative to your liquidity needs.”
— Andrew C. Smith, chief investment officer, client solutions group, Northern Trust
“If you’re investing in stocks and you can afford to put part of that investment away for several years, perhaps even a decade, you should do so to try and capture that outperformance,” Morgan said. “That 3% to 5% premium accrued over a five- to 10-year period amounts to serious growth as your capital multiplies over time.”
One way to reduce illiquidity risk is to tap into the secondary market. Investors typically turn to the secondary market when they are looking to sell an interest in a private equity fund because of an over-allocation or other strategic consideration. The buyer benefits by gaining entry and enjoying a shorter waiting period before the investment generates returns. However, the buyer must remain mindful of the potential tradeoffs: The price paid might have captured some appreciation, effectively lowering both the future return and the risk.
One of the fundamental — and significant — differences between public and private equity is in the different pricing methodologies used for these investments. While public equity securities are traded throughout the day and constantly re-priced, private equity investments are generally appraised quarterly. As a result, public equity is highly volatile, with stock prices affected by company-specific news and macroeconomic events. In contrast, private equity is less directly affected by overall economic trends or investor behavior.
The illiquidity premium of private equity investments could average between 3% and 5% above the average returns generated by the broad public equity market.
For risk-conscious investors, this presents an opportunity to diversify significantly by investing in a separate asset class or sub-asset class with very distinct characteristics. “Moving some money from public to private equity can be a form of de-risking, with less exposure to daily volatility and no need to closely monitor the latest central bank actions or geopolitical headlines,” Morgan said. “Instead of focusing on quarterly earnings expectations, an investor can develop a deeper appreciation for the quality of the businesses in the private equity portfolio and focus instead on strong business building over the long term.”
In order to take advantage of the illiquidity premium, investors have to be prepared to endure a long “J-curve.” The J-curve refers to an elongated or protracted period during which a private equity portfolio could lose money initially, or at least fail to generate an annual return, until the companies within the portfolio reach the point of profitability or are sold for a profit.
“It can take years of waiting to see returns when you invest in private equity,” Smith said. “Understanding and accepting that prolonged time frame is paramount for private equity investors.”
On the other hand, the opportunities for gains are very significant. Consider the case of the much-hyped Facebook IPO, which disappointed public equity investors while earning early venture capital investors some handsome profits. This IPO was just one example of how investing early in the life cycle of a company can prove profitable.
Because of the inherent inefficiency of the private equity asset class, with broad dispersion of results, there is an opportunity for good managers to earn above-average returns. The most highly skilled managers not only generate superior returns, they also are more likely to be able to repeat their performance given the fertile opportunities.
“Because there’s a big difference between the performance of upper-quartile and median private equity firms, investors should seek to get into those very upper-quartile fund managers.”
— Bob Morgan, managing director, alternatives group, Northern Trust
Unfortunately, access to the top tier remains difficult, and the general partners of these firms can be selective about whom they’d like to invest in their funds. A well-respected institutional investment firm can help investors gain access to the highest quality private equity fund managers.
“Because there’s a big difference between the performance of upper-quartile and median private equity firms, investors should seek to get into those very upper-quartile fund managers,” Morgan said. “We spend a lot of time building relationships with those top-tier firms and providing our investors with meaningful access.”
In the end, for those with patience, investing in private equity can not only provide diversification to a portfolio, it can also offer an investor a return premium relative to investing in the public equity markets.