As the pandemic creates havoc with markets and volatility spoils the attraction of traditional investment models used for portfolio construction, private equity is becoming a key driver of diversification and growth for advisers and money managers alike, a panel has heard.

The pandemic has brought so much uncertainty to markets that the way investors look at portfolios may never be the same. “It’s become almost cliché to say that we’re in an unusual period,” said Jonathan Armitage, chief investment officer at MLC Asset Management.

The pandemic environment will throw up a broad range of investment outcomes, Armitage explained, with returns not likely to come from traditional corners of the market.

“Investors are going to be looking at a wider range of investments to generate returns and those are going to be constructed perhaps in slightly differently ways than they have been historically,” he said.

Armitage was speaking during the first episode of Professional Planner’s new Investment Insight series held in partnership with MLC, along with investment consultant, Paul Saliba, founder of Evolutionary Portfolio Services and Serge Allaire, portfolio manager at MLC Asset Management. You can watch the full discussion here.

Indeed, financial advisers have “real concerns” about the traditional 60/40 portfolio, Saliba pointed out.

Saliba highlighted the sharp equity market drawdowns when the pandemic first hit in early March, which were accompanied by similar sell-offs in fixed income markets. This raised questions about whether traditional defensive assets are able to cushion drawdowns in shares, he said.

“All those things are concerning advisers, as well as where to get returns and yields,” Saliba added.

Adding to concern in traditional portfolio construction is that equity markets are becoming particularly concentrated, MLC’s Armitage noted, with investors often focused on a “small cluster” of tech and health companies.

“With markets so concentrated it doesn’t give the sort of diversification investors need to deal with a wide variety of potential economic and market outcomes,” he said.

Less sentiment, more diversity, less volatility

As a method of adding diversity to portfolios and reducing volatility, Saliba reckons the beauty of private equity is that it is value driven, rather than sentiment driven.

“Now there are different ways of determining that value and pricing it up but it is a representation of the value as opposed to the sentiment of the market,” he explained. “And that’s what smooths your returns.”

Private equity is a way of buying growth assets that don’t face the volatility of markets, Saliba continued, before drawing a parallel to illustrate why sentiment plays less of a role in private equity.

“If I put my home or private market business on the market very day its value would be all over the shop, not unlike the equity market. But if I have a formula… that doesn’t’ move around anywhere near as much,” he said. “That is the benefit.”

One another benefit of looking to the unlisted PE market for added diversification is that there are often “robust mechanisms” to value the assets with clear governance and audit processes behind them that are “integral to the way MLC values its own assets”, Armitage said.

Further, he explained, it’s important to remember that private assets have historically performed quite well and proven to be resilient during challenging economic environments.

“One of the drivers to that is the management teams to these businesses tend to respond very quickly to changing economic environments,” he said.

Fees: Known costs with unknown returns

A lot of emphasis in the discussion around fees focuses on the sanctity of the traditional “two and twenty” fee for active management, Allaire noted. This can work if the interests of the manager and the clients are aligned, the MLC portfolio manager says, and each side knows what they are getting into.

“We have a measured view in relation to it,” he explained. “We are happy to pay high fees for a very good manager, but he’s not going to get rich on the fees he’s charged on a yearly basis.”

The MLC team are happy to know that the fees they pay are going towards the investment expertise behind the management, but they exercise judicious caution when value isn’t being delivered.

“We’re not happy to pay high fees when you have a manager raising tens of billions of dollars and charging this two per cent and getting rich on high feel without delivering value, he said.

The focus on fees will only continue, Armitage added, as the low-yield environment continued. But that doesn’t mean MLC isn’t willing to pay a fee for management. “It is the net-of-fee return that is important,” he said.

Saliba agreed, noting that fees are a “known cost with unknown returns”. If a manager delivers the net-of-fee objective, he continued, then the fee shouldn’t matter.

“I don’t think you can totally dismiss fees but I don’t think it should be as strong a focus as it sometimes is,” he said, noting that private equity research can be among the most exhaustive – and expensive – in the investment landscape.

“You can’t just look on Bloomberg and get a bunch of statistics.”

Committing your money

While extolling the virtue of private equity, there was a consensus among the panellists that investors need to be aware of a few features to make navigating the asset class easier.

The elephant in the room, of course, is the reduced liquidity of private equity and the problems this may cause for retail investors, some of whom may not have the patience to ride out the longer maturity timeline.

“This is an asset class where you commit your money and don’t expect to take it out in the short term,” Allier said. “You can’t put all your eggs into the private equity basket.”

Investors should also try and access the top quartile of PE managers, he said. “Otherwise you shouldn’t play in the asset class at all.”

According to Armitage, the thing to remember about private equity is that it’s all about partnering with a management team; get to know them, he said, and how they operate.

“Because of the less liquid nature of these investments, when you’re working alongside a private equity firm it needs to be a proper partnership,” he said. “So we do spend a lot of time understanding how the business operates [and] understanding where they have a particular edge.”

One comment on “New portfolio construction rules are in play: Investment experts”
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    For an alternative view on the joys of investing in private equity, I suggest that the reader looks at the work of Professor Ludovic Phalippou (Said Business School, Oxford).. To put it mildly, Professor Phalippou suggests that it is the private equity managers who are the only real beneficiaries of his form of investing. Quite appropriately, his recent article is titled: ” An Inconvenient Fact: Private Equity Returns & The Billionaire Factory.” Its abstract says it all: “Private Equity (PE) funds have returned about the same as public equity indices since at least 2006. Large public pension funds have received a net Multiple of Money (MoM) that sits within a narrow 1.51 to 1.54 range. The big four PE firms have also delivered estimated net MoMs within a narrow 1.54 to 1.67 range. Three large datasets show average net MoMs across all PE funds at 1.55, 1.57 and 1.63. These net MoMs imply an 11% p.a. return, which matches relevant public equity indices; a result confirmed by PME calculations. Yet, the estimated total performance fee (Carry) collected by these PE funds is estimated to be $230 billion, most of which goes to a relatively small number of individuals. If all vintage years are included to 2015, Carry collected is $370 billion, with a performance similar to that of small cap indices, but higher than that of large cap stock indices. The number of PE multibillionaires rose from 3 in 2005 to 22 in 2020. Rebuttals from the big four and the main industry lobby body are provided and discussed.”

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