Dug Higgins says portfolio construction and asset allocation have been put through the wringer over the past two years, throwing more focus on alternative asset classes as a way of increasing the robustness of portfolios.

Private equity (PE) has developed into a major component of the alternative investment universe, and is now broadly accepted as an established asset class within many institutional portfolios, as well as becoming more accessible to retail investors.

Private equity, when properly understood, can act as a useful diversifier in a well distributed portfolio and can provide access to substantial absolute returns. The trick for the average investor or adviser is gaining that understanding.

The very nature of PE as an asset class means that transparency is limited, compared to other asset classes. And the potentially significant rewards come at the expense of challenging risks.

Like many of the alternative asset classes, the role and characteristics of PE are still not well understood in retail markets. This is particularly the case when using direct funds, which tend to be the domain of institutional investors, as opposed to the fund-of-funds (FoF) approach, which is more common on the retail side. This article will hopefully shed some light on both the positive aspects and dangers of direct PE funds.

‘Like many of the alternative asset classes, the role and characteristics of private equity are still not well understood in retail markets’

As with all alternatives, the key reason for investing in private equity is to improve the risk and reward characteristics of a portfolio. Invest- ing in direct PE funds offers the opportunity to generate high absolute returns whilst aiding portfolio diversification. There are, however, significant challenges involved for retail investors and advisers in selecting the right PE investments. Unlike the FoF approach, risk concentration is obviously significant at both the manager and asset level. This means correct investment selection is vital.

PE involves systemic asset class risk as well as investment-specific risk. This should be recognised in an industry where the high standard deviation of returns is at least partly driven by the concentrated nature of direct PE funds, which typically invest in fewer than 15 companies. While this suits the strategies of most PE managers in terms of focusing their expertise, underperformance or failure of investee companies will obviously have a greater impact.

The returns driver in PE is the capacity to create value through the operational enhancement of an invested business. This needs the correct combination of experience and process by managers who have a repeatable formula for value creation; rigorous due diligence processes that yield proprietary insights; a proven model to recruit, retain and motivate management teams; access to specialist deep sector knowledge; and a strong proprietary deal flow.

While such funds also tend to benefit from leverage, it is not leverage alone which drives success. Research has shown that approximately two-thirds of value generation is derived from operational enhancements in investee companies and one-third from the use of fund leverage. Therefore, while financial engineering is part of the equation and plays its part, the only sustainable source of driving returns in PE is increasing enterprise value.

Accurate fund selection, however, remains challenging due to a shortage of data, long-term illiquidity, limited benchmarking ability and lack of an industry beta. These issues all combine to make manager selection more of an art than a science. This in turn ups the ante for investors because, in PE, selection of the right manager is all that really matters. This is particularly relevant because, although PE is frequently portrayed as an asset class that generates significantly higher returns, the truth is that, on average over the longer term, direct PE funds seldom beat public equities.

However, all is not lost. Top-performing funds do provide substantial outperformance over public equities. Global research sources have shown that over the long term, top-quartile PE funds tend to generate about 500 basis points of outperformance over local public equity benchmark indices.

By comparison, the performance of the average PE fund is either less than or about the same as public equity indices, which reinforces the fact that direct PE funds typically display a statistically huge dispersion in performance between the top funds and the rest of the pack. This has obvious implications in an asset class which should generate a robust risk and illiquidity premium to make investment worthwhile.

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