Including private equity in a portfolio can have powerful benefits, which we covered in detail in section Why invest in private equity?. Seasoned investors will be familiar with the level of thought and analysis that goes into selecting which new assets enter a portfolio, then rebalancing periodically to ensure that it remains on the right track.
Here, we cover the process of taking stock of your portfolio and what it needs and selecting which fund style might suit these needs. Then, we look at how you might take a top-down approach to choosing a strategy and a bottom-up approach to manager selection, before finishing with key elements of monitoring and rebalancing.
Much of this will be familiar to experienced investors, but there are critical differences between how private equity and traditional assets behave in a portfolio, so it’s worth going through systematically. For simplicity, we will assume that you are managing your own portfolio and purchasing either a primary or secondary investment in a fund managed by a General Partner.
Before you include a new asset in your portfolio, it’s necessary to have a clear picture of what overall strategy you’re aiming for and what your immediate objectives are.
Define your overall portfolio strategy
Take stock of your existing portfolio
With your overall strategy and needs in mind, consider your portfolio as it is now compared to how you want it to be. This guides your asset selection going forward - all with the goal of optimising diversification to meet your strategy.
Use the answers to these questions to define your immediate objectives
Clearly lay out your objectives for this new iteration of your portfolio. You should return to this step periodically to rebalance your portfolio and ensure that you don’t lose track.
Now that you have a set of objectives for your overall portfolio, you can use these to define your percentage allocations to individual asset classes based on their risk/return profiles. The chart below shows recent data on the allocation of US College Endowment funds to different asset classes - you can see that the larger the fund, the higher the allocation to private equity.
As an individual investor, the considerations are different to those of an endowment fund which seeks to retain capital over a rolling period - the fund never expects to “close”. To get a better idea, we can look to research from Vanguard that maps out the expected return and risk (volatility) results from different allocations¹. This example uses the traditional 70% Equity / 30%
Bond portfolio as a starting point and assumes that instant, continuous rebalancing is not possible due to the illiquid nature of private equity.
This is purely illustrative, to give an idea of how including private equity can affect portfolio return and risk: it does not represent a recommended asset allocation. There is no “correct” allocation profile, but it is essential to understand how the balance of assets affects both portfolio return and risk overall - to make sure you are always in line with your overall strategy.
Taking the objectives you defined, you can look at the available options and shortlist particular strategies based on how they fit your risk/return profile and cash flow, liquidity or diversification needs. This is taking a top-down approach first, looking at fund style, focus and vintage to narrow down your field of view before going into detail on selecting the right manager.
Note: If you prefer, you can select a series of managers first (bottom-up), then select the right strategy from this list (top-down) after. That said, since there are so many private equity funds available, carrying out manager due diligence on every available fund before narrowing down is unlikely to be a feasible option. The suggested order is likely to make the process smoother.
In public market investing, strategies are often split into three styles: Growth, Value and Income. Now that you know your objectives, it can be helpful to split your options into these three buckets to narrow down your strategy.
Please note that the examples below are by no means the only options available and they do not represent recommendations to invest. They are simply intended to illustrate how you might translate your objectives into a particular sub-sector. See Explore strategies for more on each sub-sector.
Most funds will clearly focus on an industry or sector, with particular emphasis on sub-sectors. They will also operate in a particular region - even the majority of funds with a global remit will concentrate on a few regions. Consider your strategy to select a sector/region focus, looking for:
Sectors that might:
Regions that might:
There are a few elements at play here that make it important to diversify private equity investments across vintages:
Smoothing market cycles. Private equity has historically outperformed public equity across full market cycles (see Why invest in private equity?), but returns tend to vary depending on the phase of the business cycle. For example, if a fund starts investing in a downturn, it is likely to have a larger selection of distressed, undervalued assets to choose from, then be able to exit at a point when the market is peaking. The opposite is true for a fund investing at a market peak: assets are likely to be expensive and run the risk of being undervalued when brought to public markets at exit.
Since the market timing is unpredictable, diversifying across vintages helps to smooth out this cyclical risk to create a return profile that represents the asset class as a whole.
Creating a self-funding portfolio. We covered the structure of private equity returns in How Does Private Equity Work?, along with why a flatter J-Curve is generally better for smoothing out an investor’s cash flow. When it comes to building a portfolio, investors can use this dynamic to their favour.
By diversifying across vintages, the distributions from an earlier vintage can be reinvested as commitments for a later vintage - creating a self-funding portfolio that increases in value
Once you have a strategy in your sights, the final step before investing is to select the best manager - and fund - within that strategy that fits your portfolio. It is important to be careful in selecting a manager, since the dispersion of returns between managers can be broad:
Dispersion of private equity funds’ outperformance over the MSCI World Index per vintage year².
As we covered in section How does private equity work?, the launch of any private equity fund comes with a series of materials encompassing everything a potential Limited Partner needs to know. Carrying out manager due diligence involves - at the least - looking at the Private Placement Memorandum (PPM) and marketing presentations for each fund.
Here are some key elements to look out for when selecting a manager:
Bear in mind that a fund will not even begin to see distributions until the harvesting period, so strategies that target a clear market opportunity based on long-term, secular trends that the manager has experience with are likely to provide more solid results.
A manager’s track record can only say so much in isolation: a fund may have performed well for any number of reasons, especially in favourable market conditions. This makes it essential to benchmark a manager’s performance against comparable funds of the same vintage as well as the public market equivalent.
Besides top-line growth, creating value through multiple expansion is a solid strategy, so if a manager has a good track record of selling at high exit multiples compared to entry multiples, it can be a sign of an experienced entry and exit strategy. The final main strategy is financial engineering (working with leverage or capital structure), which is widely considered to be riskier, as it magnifies both gains and losses.
4. Deal sourcing and diligence. Before value creation can begin, performance hangs on a manager's ability to source opportunities within their predefined area of focus. Managers vary in their deal sourcing methodology, from relying on proprietary networks to operating top-down methodologies that start with themes, analyse all of the potential companies, then narrow in on potential targets. A structured approach is critical, allowing a manager to continuously bring in excellent opportunities and offer repeatable success.
5. Investment team. A manager is - like any company - only as strong as its talent. Fund materials offer plenty of detail on the experience, past performance and expertise areas of each member of the investment team, along with which team members will be dedicated to the running of the fund.
6. Unrealised portfolio / reinvestment. Almost all managers will begin raising a fund while a previous vintage in the same strategy is still operating. In the case of larger managers, there can be up to three or four funds “alive” at the same time. The unrealised nature of these portfolios can disguise potential negative performance, so it is worth looking into the individual companies that a fund still holds to get a better picture.
On the other hand, many managers allocate a portion of a fund to re-invest in existing portfolio companies i.e. unrealised assets from funds of earlier vintages that the manager does not deem ready for exit. When this strategy is carried out effectively, it can be an excellent source of proprietary deals, doubling down on a manager’s conviction to deliver attractive returns.
7. Fees and carried interest. The fee structure of a fund is not only critical from the Limited Partner perspective - since it defines the difference between Net and Gross returns - it also drives the performance and dedication of the investment team (see How does private equity work? for more).
For example, a fund that distributes carried interest on an aggregate fund basis (“European Waterfall”) will benefit Limited Partners with earlier distributions, while a deal-by-deal distribution structure (“American Waterfall”) delivers later distributions but might provide greater motivation for the investment team.
A portfolio represents a selection of assets that are changing constantly, whether it be the value of companies increasing as they - and fund managers - create value, or due to changing market conditions. This means that a healthy portfolio is dynamic in nature, monitored periodically and rebalanced wherever necessary to ensure that it fulfils the goals you set out to achieve.
Please note that dynamic does not mean “constantly changing”. When considering whether to make changes to a portfolio, the decision should be made carefully and only when necessary - not in a knee-jerk reaction to every update from the General Partner or change in the market.
Capital call monitoring
A unique element of a private equity investment is that an investor can’t just buy a stake and see what happens. Becoming a Limited Partner means committing to delivering capital when the General Partner makes the call - usually within 7-10 days. So it is important to keep track of when those capital calls are likely to come and ensure that you have appropriate amounts of cash - or liquid assets - in your portfolio to honour them.
Any portfolio will be affected by changes in the market, economic conditions and political decisions - whether short term shocks or policy changes with long term effects. Keeping track of the landscape in which your investments are operating is essential.
A quality manager will be closely monitoring market conditions and altering the strategy appropriately, but bear in mind that this may cause the fund to move in a direction that goes against your objectives. For example, if you included that particular fund in your portfolio for sector or regional diversification purposes, a market shock may cause the fund to become overweight in a sector or region you were trying to reduce.
- Entry Multiple. This is a simple calculation of a company’s purchase value compared to earnings at the time: enterprise value (EV) divided by Earnings Before Interest, Taxes, Depreciation (EBITDA). A General Partner will seek to negotiate a low entry multiple, in the hope of increasing this ratio as much as possible during ownership.
- Exit Multiple. Calculated at the time of exit in the same way as Entry Multiple (EV divided by EBITDA), a General Partner will seek to create the highest possible Exit Multiple during ownership. The two metrics are especially insightful when compared to one another, illustrating how much the fund has (or hasn’t) increased value during ownership.
- IRR (“Internal Rate of Return”). IRR is a return measure of both speed and size by which an investment offers a return, so it takes into account the time value of money. It is usually calculated by dividing the size and timing of a fund’s cash flows (in the form of capital calls and distributions) by the net asset value. Gross IRR is often used to show performance at the fund or company level. There is no standard method for how to build fees, carry or expenses into a Net IRR calculation, so this varies for each fund manager.
- MOIC (“Multiple on Invested Capital”). MOIC is a measure of raw investment performance, measured by dividing the total value of a fund (or investment) by the total invested capital. Since it does not take time into account, it is most useful combined with a measure such as IRR. For example, one investment with a MOIC of 5.0x over a period of one years has a far better IRR than one with the same MOIC over ten years. MOIC is often shown as both Gross and Net figures - before and after fees.
- TVPI (“Total Value to Paid-In”). Also known as “Investment Multiple”, this is a way of measuring the fund’s performance as a multiple of cost to Limited Partners. It is calculated by summing the cumulative distributions of the fund and residual value and dividing by the paid-in capital. Like MOIC, it does not take into account the time value of money. But - since it is based on the cost to Limited Partners, not to the fund - TVPI almost always refers to “Net TVPI”, meaning it is calculated after management fees.
- Loss Ratio. Loss Ratio measures how much of a manager’s investments - or a particular fund’s investments - that were realised at a loss. It is a simple way of illustrating a manager’s track record at downside protection, reflecting their ability at investment selection and exit management for underperforming investments. Loss ratio is calculated by dividing the percentage of capital realised below cost (minus any recovered proceeds) by the total invested capital.
While private equity investment is generally considered to be a long game, it is still essential to keep track of performance during the life of a fund. Monitoring the value and performance of a private market asset is a lot more difficult than public assets (see sidebar below, but the principle is much the same, looking at the following:
Value. As asset values change, the balance of the portfolio can shift - often dramatically - over time. For example, if a 20% allocation to private equity performs very well and increases in value, while 40% in public equity decreases in value due to a downturn, this could shift the dollar value of your portfolio to 25% in private equity and 35% public equity. This drastically changes the balance of overall return and risk in your portfolio.
Returns. Monitoring returns as a fund progresses can be misleading, since key metrics (see sidebar above) will fluctuate over time, even if the final return is attractive. With that in mind, it is worth comparing returns to comparable funds of the same vintage, as well as expected return at this point in the fund’s lifecycle.
Risk. Just as returns on an asset and portfolio level will fluctuate, so will risk. This comes as a result of economic or market conditions, meaning that it is important to continuously assess whether the risk profile of a fund still fits with your portfolio goals.
Why can’t you use traditional models for private equity valuation and allocation?
Traditional asset valuation and allocation models are based on Modern Portfolio Theory (MPT), which takes into account certain characteristics of the portfolio and the investor:
We have covered in detail how public and private assets behave differently in previous sections. The characteristics that we have covered in previous sections combine to make traditional pricing models ineffective when it comes to private equity:
Periodically - as the output of ongoing, regular monitoring - you should rebalance your portfolio to ensure that it remains within the return and risk margins you are comfortable with. There is no “best” frequency, but you might choose:
Replacing a closing fund
Up to this point, we have looked at the life of a fund as a self-contained lifetime, with a beginning and an end. But - for most investors - a portfolio will be ongoing, so planning for the end of a fund’s life is an essential part of investing in private equity.
Years after the original fund stakes were purchased and the investor became a Limited Partner, it is likely that the goals and objectives of the portfolio have changed. It could be the case that by this point, the portfolio contains a series of other private equity stakes of varying vintages, which means that replacing the closing fund is a matter of course. But - as always - it is an excellent time to take stock of the portfolio and make sure it is on track to fulfil key objectives.
Important Information: Past performance is no guarantee of future results. Any historical returns, expected returns, or probability projections are not guaranteed and may not reflect actual future performance. Your capital is at risk. Please see https://www.moonfare.com/disclaimers.
² Source: BlackRock Private Equity Partners, July 2021. The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results. Dispersion of outperformance over the MSCI World Index per vintage year and in aggregate as of December 31st 2020 – all in USD. Private Equity performance data sourced from Burgiss covers vintages 2002-2018, 2,209 funds, and USD 2,399 billion in market capitalisation. Private equity strategies include: Buyout, VC (Late), VC (Generalist), and Expansion Capital. All returns are net of management and performance fees.
The definition of the asset class as well as its main characteristics.
Not only higher returns and diversification. All the arguments for investing in private equity.