A character of its own
Peter Lockyer discussess where private equity fits in investors’ portfolios
Over recent years, private equity has provided substantial returns for many investors. Other investors have been wary about private equity. Part of the reason for this caution is a belief that such investment carries additional risks that are peculiar to this type of security.
An analysis we have undertaken shows that:
o The volatility of returns in the private equity market may be lower than generally perceived, especially relative to listed equities;
o Even with adverse assumptions about the correlation of its returns to listed equities, an investment of up to 10% of an equity portfolio in private equity would not substantially increase the total volatility of the portfolio;
o Over the past few years, the returns on many private equity funds have more than compensated their investors for the risks involved. Investors who have not previously invested in private equity should reconsider the size and nature of these risks against the opportunities that private equity offers;
o The pattern of returns from private equity means that – although it does not satisfy all the tests of being an asset class in its own right – it should be treated separately from listed equities in performance attribution analysis;
The variation in returns from different funds, and over time, suggests that investors should conduct equally rigorous due diligence research on private equity fund managers as they would for listed equity fund managers. Investors should ask for details of the track records, experience and style/process of the managers concerned just as they would for managers of other assets.
There has been a considerable variation in the returns that have been achieved by different private equity funds. Part of this difference can be explained by the differences in the market segments in which these funds were invested. But investors need to consider a diversified approach to this investment just as they would for any other investment;
These results imply funds should consider a strategic allocation to private equity in their benchmarks of 10% of their total equity exposure. We would suggest that at most 3% of a total fund’s equity allocation should be invested in a single private equity fund.
Private equity does not clearly satisfy all the conditions of a separate asset class, but the pattern of returns means that it should be treated separately from listed equity in any performance attribution.
The definition of an asset class is a group of securities that over the long-term:
o The individual securities of which behave in a similar manner or expose an investor to similar economic or other exogenous factors;
o Collectively behaves in a manner sufficiently different from other asset classes that an investor can diversify his risk by investing in portfolios of securities in these different asset classes; and
o Commonality of the means of investment and its tax and regulatory treatment.
Thus listed equities and debt, domestic and foreign securities are different asset classes, but an industrial sector of a listed equity market is not. The basic characteristic of private equity is its lower level of liquidity compared to public equity. But this is a characteristic that, to a degree, is shared by smaller capitalisation listed companies.
Private equity investment can expose an investor to similar economic and exogenous factors. For most investors it is accessed through funds, rather than directly, and these funds tend to have similar legal and tax structures. So on these grounds private equity may be considered an asset class in its own right.
The second test is whether the returns are sufficiently diverse from other asset classes. One of the problems with private equity is the paucity of data, especially over the longer-term. This means that it is difficult to test the proposition that private equity is a separate asset class compared to other equity. However, when values are put on the underlying investments in a private equity fund, they will take some account of the valuations placed on similar companies in the listed market. Furthermore, any disposal will also have some regard to the listed market’s treatment of similar companies. Therefore, a priori, one should expect some level of correlation between the returns on private equities and listed equities.
The uncertainty over whether private equity is a separate asset class arises most frequently with attribution analysis. If private equity is considered part of the listed equity class then its returns are attributed to stock selection of public equities. If it is considered a separate asset class then any allocation to private equity that is not included in the benchmark will be attributed to asset allocation. The difference between the actual return on the chosen private equity fund and the benchmark return for this asset class will be attributed to stock selection.
Even if the allocation to private equity is small the former approach may give rise to anomalies in the initial years when the returns on private equity funds can be negative. If public equity is rising during this period, this will appear to be poor stock selection by the investment manager. For example, if a fund invests 3% in private equity and during the initial year the return on public equity was 20%, the fund would appear to have under-performed the public equity benchmark by 0.6%.
The returns on private equity funds follow what is described as a J-curve. So for several years after launch the returns will be low and possibly negative. This means that if the returns on private equity are included as a stock selection decision in the performance attribution, the investment manager may be reluctant to include an allocation in his portfolio because of the short-term performance drag. This would be the case even if over the longer-term, five years say, the return was comparable to or better than public equity.
Therefore, from the perspective of the fund sponsors, wishing to make a meaningful allocation to private equity, it would be better if allocations to private equity were viewed as an asset allocation decision for performance attribution analysis purposes.
Peter Lockyer is a managing director at Merrill Lynch Mercury Asset Management, in London. He is author of a forthcoming paper ‘Private equity investing: overcoming the information gap’ on which this article is based