In both rising and falling markets, private equity has long appealed to institutional investors because it has historically outperformed quoted equities. What’s more, it can play an important role in diversifying a fund’s investments. For most funds, however, the major stumbling block between recognising these points and actually taking action to invest in private equity, is integrating it into the asset allocation process.
We look at the challenges in this particular area and highlight the importance of implementation in developing a successful strategy.

What’s everyone else up to?
A recent survey of tax-exempt organisations , shows a steady increase in European respondents’ average strategic allocation to private equity (Exhibit 1). Allocations have more than doubled since 1996 and are expected to increase further over the coming two years. The allocation level in Europe remains below that of North American institutions, with the average allocation of these respondents to the same survey being 7.5%.
The experience of other funds provides a useful barometer, however, it does little to aid in setting the appropriate strategy for an individual fund. Asset allocation is the fundamental risk management tool available to investors and as such is fund specific. Determining an appropriate asset allocation is not a trivial exercise and alternative investments, while presenting many opportunities for investors, complicate this process.

What’s so special about private equity?
Most people would anticipate earning higher returns from private equity than from publicly quoted equities. The anticipation would be for a higher risk than quoted equities but with some correlation with quoted equities. It is possible to use fundamental economic reasoning to produce expectations for the behaviour of private equity which is important because there are few, if any, historical return series that can be used as a basis for producing reliable and stable assumptions for the future. Most return series are distorted by appraisal pricing and timing lags. It is important to remember that no investable index exists in private equity as most index returns are in fact universe returns. Recognising all these factors, a reasonable assumption for the return premium in excess of quoted equities is between 3% and 5%. The rationale for higher returns is set out below.
Investors in private equity cannot easily trade in and out of securities of private companies and often it will take a number of years for the value potential of a private company to be realised. In this case, investors in private equity would expect to earn a liquidity premium.
Privately held companies are much less actively researched than their publicly traded counterparts, making this a less efficient asset class and allowing for interesting entry pricing opportunities. Post investment, private equity managers are able to obtain and act upon non-public, inside company information in a way that is not available to investors in publicly quoted securities which should contribute to a return premium.
In addition, most private equity investors will be much more closely involved in the management of the company. This will include assisting in the strategic development of the business, devising attractive management incentive plans, aligning the interests of ownership and management and taking a closer corporate governance stance. Indeed, this approach to increasing the value of a company is becoming increasingly popular in quoted equity markets. In addition to contributing to the operating side of the business, private equity managers will use their expertise to optimise the financial structure of the company.
The expected return from private equity will depend very much on the life cycle of the company and the type of private equity investment. For example, an early stage venture capital financing of a start up project, carrying the associated risks, will have a higher expected return than the mezzanine debt financing of a mature business. It is also important to point out that private equity is cyclical; different types of private equity funds display different return characteristics, so funds of different vintages will produce varying returns.
Investing in private equity is an active management game. One of the biggest determinants of the actual return produced by a private equity investment will be the skill displayed by the private equity manager. Exhibit 2 compares the dispersion of returns achieved over a 10-year return across quoted equities, both large cap and small cap and private equity.

How much private equity?
Asset allocation is often seen as a complex statistical exercise, relying on some form of optimisation of assets and liabilities. Optimisers are useful in providing insights into efficient asset mixes, but they are highly sensitive to changes in input assumptions. A common and widely recognised limitation of statistically based optimisation is the need for precise and accurate information about the behaviour of asset classes. Small changes to forecasts can lead to widely differing policy mixes. To combat this, many practitioners either adjust the input assumptions or constrain the range of possible policy allocations to include the preferred outcome. It is hardly surprising then that asset allocation studies came to be viewed with scepticism.
Russell adopts a two-stage process to determining allocations to alternative assets. This involves assessing the core equity/bond allocation using an asset liability model and enhancing this position with a more qualitative evaluation of the risks and rewards of potentially performance-enhancing investment opportunities.
The allocation to alternative investments and private equity in particular is based more on a qualitative assessment of the investments coupled with sound judgement and logic. There is no attempt to select an allocation based purely on a mean-variance (or another) optimiser. Further modelling can be used to test the robustness of the forecasts, but should not be used as the primary decision criteria. These models will simply report the favourable position already assigned to these alternatives in the forecast assumptions.

Implementation is key
The return enhancement expected from private equity will only be achieved if the allocation is implemented successfully. This requires a well diversified portfolio of holdings and a skillful choice of private equity managers.
Private equity is cyclical in nature. Therefore diversification needs to be carried out not only across geography and industry (as with quoted equities), but also across stage and vintage year. In addition, investors need to diversify by manager, selecting the ‘best of breed’ manager in each sub-segment of the private equity universe. As shown above, there is more dispersion in the performance of private equity managers, than in the performance of their quoted equity counterparts.
As more investors have moved into the private equity arena, there has been a shift away from single fund partnerships to fund of funds vehicles. These vehicles offer investors greater diversification than can be achieved by most funds on an individual basis, expert manager selection and also the resources required to manage and monitor a private equity fund programme.
Many investors now include an allocation to private equity as a means of improving the return potential of their assets and diversifying the associated risks. One of the biggest difficulties faced by investors is in identifying a robust process for determining an appropriate allocation.
There are a number of reasons why the traditional asset liability optimisation models fail to work satisfactorily for these asset classes. These models will merely exaggerate the imperfections in the data and assumptions.
For an investor to have confidence in their allocation to private equity, the results of which will not be known for many years, a qualitative assessment of the asset class and the investment vehicle used to implement will need to be made. This will include an assessment of the extent of the diversification and skill employed by the private equity manager.
Simply making an allocation to private equity will not in itself lead to higher fund returns. Each fund’s results will depend on how successfully it is implemented.
David Rae is a consultant at Russell Investment Group in London