Edward Mott explores the role of private equity and venture capital in post-recession equity portfolio optimisation

Among the institutional investors that suffered during 2008 were the erstwhile
poster-children of portfolio optimisation and efficient return strategies - endowment funds like those of Yale and Harvard. It is only natural that well understood and formerly well-regarded portfolio construction theories are being questioned: why were they not able to save Yale, with its hefty 30% allocation to private equity, from suffering a $7bn (30%) overall write-down in 2009? Or Harvard, which lost $11bn? What approach should investors now follow to protect against similar crises in the future? In particular, what role should allocations to private equity and venture capital now play in an investor's diversification strategy?

This article examines some of the literature to provide an overview of the impact of incorporating private equity and venture capital allocations on a portfolio's diversification, performance, and protection from risk.

Portfolio optimisation and modern portfolio theory held that a diversified portfolio - incorporating assets which have a low performance correlation with each other - could offer higher returns at the same level of risk. From this theory derived the approach that adding alternative asset classes, such as venture capital, to a portfolio can increase its risk-return ratio.

So how far have the principles of modern portfolio theory really translated into real-world benefits for investors? The embrace of these principles, and the resulting high allocations to alternative assets, including venture capital, has been cited as a key explanation for consistent outperformance by major US endowment funds, with respect to public markets (for example, see Josh Lerner, Antoinette Schoar and Jialan Wang in their 2007 Harvard Business School Finance Working Paper, ‘Secrets of the Academy: The Drivers of University Endowment Success'). A considerable mass of data on actual portfolio performance has been accumulated in recent years, but the evidence it presents is mixed.

Most studies (eg Kaserer & Diller (2004); Schmidt (2004); Kaplan & Schoar (2003); Ljungqvist & Richardson (2003)) suggest that private equity investments generally have low performance correlation with mainstream investments. Some also find that private equity investments can deliver outperformance against mainstream equities, as represented by the S&P500 (eg, Kaplan and Schoar (2003; 2005) and Ljundqvist and Richardson (2003). However, others report underperformance of VC and private equity in relation to public markets (Kaserer and Diller, 2004; Schmidt, 2004; Driesson et al, 2011). Some more recent studies (Kortweg and Sorenson, 2010; Driesson et al, 2011) also suggest that many VC firms can be strongly pro-cyclical (they have a high level of beta) - a finding that would tend to question their value as diversification instruments.

Experience counts
One of the most recent analyses of private equity performance casts new light on this evidence base, by considering a much broader sample of private equity funds dating from 1984 to 2010 (and thereby encompassing the most recent financial crisis and subsequent recession). Robinson and Sensoy, using a sample of 837 venture capital (VC) and buyout funds provided by a large group of limited partners, show that private equity investments do, indeed, deliver significant outperformance, on average, against the S&P500 index.

They also find that both VC funds and buyout private equity funds are pro-cyclical. However, while buyout and private equity funds do underperform in absolute terms during economic down-cycles, their outperformance relative to the public equity markets remains largely unchanged. Hence, this study suggests, venture capital and private equity more generally might not be delivering the anti-cyclical upside that an ideal diversification strategy would incorporate. However, their performance is significantly and positively differentiated from that of public equity markets alone.

Research also indicates that considering average returns across a private equity or venture capital sample overlooks the fact that the individual experience of fund managers can have a significant impact on venture performance. For example, Lerner (1994) finds that more experienced fund managers are more proficient at taking companies to market at maximum valuations. Indeed, Novak et al (2004) find that the experience of fund managers is the single most important factor determining
fund performance. As discussed below, research also indicates that investment strategy - in particular the investment stage - also has a big impact on performance.

Faced with such a contrasting set of findings, it is difficult to draw firm conclusions as to the value of private equity as a diversification tool - particularly against public equity markets.

Risk-averse
A recent investigation attempts to provide a more detailed picture of the ways in which venture capital and other alternative assets can affect portfolio optimisation strategies. Cummings et al use pre-determined parameters of risk to determine the optimum breakdown of different classes of assets within portfolios targeting given levels of outperformance versus risk. They find that private equity, and venture capital specifically, should play an important role in achieving an optimised portfolio.

Perhaps counter-intuitively, they show that venture capital allocations should play a particularly important role in more risk-averse portfolios - and that these findings hold true to an even greater extent when considering data gathered since the crisis of 2008-09. In other words, the role of venture capital and private equity was actually under-estimated prior to 2008. Since that time, these asset classes have, in general, performed more strongly in relative terms - not suffering the major fluctuations and volatility experienced in the public markets.

A more nuanced perspective is provided by a 2006 paper, which uses a data sample of over 2000 realised private equity projects to explore how different classes of private equity correlate with public markets, particularly during bearish conditions. Mattheus Ink (2006) found that, overall, there is a low public equity correlation from all classes of private equity considered.

Moreover, in agreement with Robinson and Sensoy, he shows that private equity, in general, outperforms. However, the detailed findings underpinning these broad conclusions contain a number of important lessons for investors considering the role which private equity and venture allocations can play in optimising their portfolio:

1. Private equity and venture capital offer outperformance under most market conditions, but not in bear markets.
2. Private equity does show low correlation with public markets.
Although private equity investments are pro-cyclical (they suffer under poor market conditions), they do offer good potential for diversifying a pure public equity portfolio.
3. Expansion investments and later stage investments do exhibit positive hedging capabilities

Although private equity investments, as a whole, do not appear to provide good hedging against the worst public market performance, expansion and later stage venture funding, focused on growth capital, do appear to generate outperformance under bear market conditions. The author suggests that the greater market dependency of earlier-stage investments results from the relative lack of detailed information on specific investment opportunities. Hence, while growth investors and later-stage private equity investors are able to base their decisions on robust, company-specific performance data, earlier stage investors tend to rely more upon prevailing market conditions to inform their investment strategy.

Insurance
Faced with these findings, what, in the post-recession climate, should be the role for private equity allocation in developing optimal risk-return strategies?

In a recent paper addressing precisely that question, Amenc et al (2011) show that diversification strategies within an equity portfolio cannot, by themselves, offer risk protection in abnormally poor market conditions - under extreme market conditions asset performance tends to converge. This observation leads the authors to two broad conclusions: first, that diversification is a long-term and cross-cycle strategy to optimise portfolio returns - not a protection against short-term fluctuations; and second, that risk-conscious investors should, therefore, pursue insurance strategies to offer absolute risk protection.

To summarise, we can say that private equity has historically played a key role in optimising the risk-return efficiency of investment portfolios. Private equity and venture capital investments show, under the majority of market conditions, a low correlation with public equity performance. Private equity also tends, on average, to outperform public market indices - and there is evidence to suggest that later stage investments consistently outperform public market benchmarks, even under adverse market conditions. However, that does not change the shortcomings of relying on diversification and portfolio optimisation as a risk protection strategy.

Over time, inclusion of private equity as part of an optimised portfolio can deliver higher returns than the public market benchmark - and this is likely to be true, especially in a new-found growth environment. But even the most efficient portfolios are not immune to major market fluctuations. Portfolio optimisation and diversification is a strategy for long-term asset allocation: investors should also incorporate absolute risk protection, such as the insurance strategies, to deal with the short-term volatility associated with environments such as that of 2008-09.

References
Amenc, N., Goltz, F., & Stoyanov, S. (2011). A Post-Crisis Perspective on Diversification for Risk Management. An EDHEC-Risk Institute Publication.
Cumming, D., Has, L., & Schweizer, D. (2009). Strategic Asset Allocation and the Role of Alternative Investors.
Driesson, J., Lin, T.-C., & Phallippou, L. (2011). A New Method to Estimate Risk and Return of Non-Traded Assets from Cash Flows: The Case of Private Equity Funds. Journal of Finance and Quantitative analysis, Forthcoming.
Ink, M. (2006). Private Equity Returns: Is there really a Benefit of low Co-movement with Public Markets? National Centre of Competence in Research Financial Valuation and Risk Management: Working Paper No. 334.
Kaplan , S., & Schoar, A. (2003). Private Equity Performance: Returns, Persistence and Captial Flows. NBER Working Paper.
Kaplan, S., & Schoar, A. (2005). Private Equity Performance: Returns, Persistence and Capital Flows. Journal of Finance, 60:1791-1823.
Kaserer, C., & Diller, C. (2004). European private equity funds - A cash flow based performance analysis. Research Paper, European Private Equity & Venture Capital Association (EVCA).
Kortweg, A., & Sorenson, M. (2010). Risk and Return Characteristics of Venture Capital-Backed Entrepreneurial Companies. Review of Financial Studies.
Lerner, J. (1994). Venture Capitalists and the Decision to go Public. Journal of Financial Economics, 293-316.
Lerner, J., Schoar, A., & Wang, J. (2007). Secrets of the Academy: the Drivers of University Endowment Success. Harvard Business School, Working Paper No. 07-066.
Ljungqvist, A., & Richardson, M. (2003). The Cash Flow, Return and Risk Characteristics of Private Equity. Working Paper, Stern School of Business, New York University.
Novak, E., Knigge, A., & Schmidt, D. (2004). On the Performance of Private Equity Investments: Does Market Timing matter? Working Paper, CEPRES.
Robinson, D., & Sensoy, B. (2011). Private Equity in the 21st Century: Liquidity, Cash Flows, and Performance from 1984-2010. Research in Financial Economics.
Schmidt, D. (2004). Private equity, stocks- and mixed asset portfolios: A bootstrap approach to determining performance characteristics, diversification benefits and optimal portfolio allocations. University of Frankfurt, CFS Working Paper Series, No. 12.

Edward Mott is CEO at Oxford Capital Partners. He would like to acknowledge the contribution to this article of his colleague Michael Conway