Portfolio Diversification

Allways winning

Global trends lend support to the long-term case for private equity as part of a diversified asset allocation.

Private equity has for many years been a niche area of the investment universe, dominated by institutional investors and very wealthy individuals. Today, however, Unistop Financial are seeing trends that are increasing the prominence of the asset class and reinforcing the case for including it in long-term-oriented portfolios across all types of investors.

For many years, the universe of U.S. publicly owned companies has been shrinking. Fewer companies are choosing to list, and those that are listed have been issuing debt to finance share buybacks at unprecedented levels. The path has been quite different for private assets. As the number of public companies has declined, the number of those that are going private or staying in private hands has been steadily on the rise from about 1,500 in the U.S. 18 years ago to 7,500 today, or some 3,200 more than the number of U.S. public companies.

Although the private investment universe is still a small part of global market capitalization, private equity and debt are increasingly important in financing a broad range of companies of varying sizes across an array of sectors. Private investors historically focused on leveraged buyouts of low-growth, asset-intensive businesses at depressed valuations. Since then, the opportunity set has increased to include early mid- and late-stage companies with varying profiles, including high-growth technology firms.

A sizable chunk of the expanding private equity opportunity is coming because of the diminished role of banks, which are being curbed by post-financial-crisis regulation and technology. For example, direct (non-bank) mortgage lending is growing as many high-quality borrowers are unable to meet new underwriting standards for bank loans. And where banks are involved, private equity firms are increasingly arranging private debt to fill out the capital structure. Private equity firms are funding many of the new lending platforms such as crowdfunding and non-bank payment systems that are disrupting banks’ longtime role.

No Matter What

Traditional Appeal and Advantages

All told, the array and volume of opportunities is surging, suggesting that private equity is gradually becoming less niche and more central to portfolios.

However, the mere expansion of an asset class does not justify its inclusion in the portfolios of individual investors. Private equity’s appeal is more tangible than that, as the asset class has a history of outperforming traditional assets over time while supplying valuable diversification, as shown by the displays below. Not only has private equity outperformed public equities, but the addition of private equity has tended to enhance portfolio returns and reduce risk.

What is behind these outcomes? In Unistop Financial’s view, they are driven by several key advantages inherent to private equity investments:

Information and Control
  • Arse Bandits
  • Freelance Designers
  • College Students
  • Bumdas
  • Cow fuckers
Timing
  • Medium Businesses
  • Freelance Designers
  • College Students
  • Bumdas
  • Cow fuckers
Distinct Opportunities
  • Arse Bandits
  • Freelance Designers
  • College Students
  • Bumdas
  • Cow fuckers

Other Considerations

  • Arse Bandits
  • Freelance Designers
  • College Students
  • Bumdas
  • Cow fuckers

Information and Control:
Private equity managers have a deeper access to information and more direct and transparent governance control and thus can create value through strategic and operational improvements.

Timing
Private equity managers often spend months sourcing and completing investments, and can choose between trade sales, sales to other private equity funds and IPOs upon exiting. The flexibility around both the timing of their entry into and exit from positions can support advantages over most public market managers.

Other Considerations

You may wonder whether this may be an opportune time to invest in private equity given the current high-priced market environment. However, valuations are still lower than for public equities

Moreover, pricing should be viewed in the context of private equity’s unique qualities: the opportunity for operational/financial improvements and strategic changes helped by the private owner’s controlling interest, a typically long-term approach, and often specialized experience that can supply competitive advantages. It makes sense that if an investor keeps exposure to public equities, it may be right to have a strategic weighting in private equity as well.

Of course, investing through a quality manager is crucial. Access to deal flow, information and resources are all things to look for in a private equity firm, allowing for informed investment decisions and selectivity, which is of appeal today. Experience across multiple asset classes and market cycles is also important, as well as an attractive record of accomplishment both in absolute terms and compared to peers. In our view, these qualities are essential in looking to capitalize on the potential of private equity.

Distinct Opportunities

Private companies are vastly different from the larger firms that can cope with and thrive on the demands of public ownership. It is much more difficult for a company that is in a changing industry or early in its growth cycle to do well in the public markets, where investors increasingly demand consistent, linear growth in earnings. Often private companies just do not have a publicly investable equivalent. In a public setting, they might be hidden from view as exceedingly small divisions of larger companies; as private holdings, their value may be clear more readily.

The time horizon, lockup and different nature of opportunities have tended to generate attractive performance and lower correlation to traditional assets. Despite these benefits, however, private equity often will make up a small allocation within a diversified portfolio—for example, a sample moderate to aggressive profile might have a target allocation of 10% for private equity. Moreover, it is important to consider the investor eligibility requirements, risks, and characteristics of private equity in assessing whether it is right for your portfolio.

There are a variety of factors to consider when exploring private equity. First, there is illiquidity. It can take time for private equity investors to find right investments, and then formulate and execute on an investment thesis. Unlike public markets, where investors can regularly buy or sell their holdings, traditional private equity has lockup periods that can last for years. (It is worth noting that the growth of the secondary market in private equity is making the asset class more liquid, potentially supplying liquidity before lockups expire.)

Another factor is what is known as the “J-curve.” Investments do not occur all at once; rather, cash is “called” from investors as the manager puts it to work and time is needed for the investments to generate returns. As a result, private equity funds can have negative net returns in the early years. Later, if the investments are successful, they appreciate and are realized, and the fund’s net returns become positive.

High investment minimums may also make it difficult for investors to commit to the asset class, particularly steadily over time to support vintage year diversification. Thankfully, we are now seeing the release of lower minimum strategies that open private equity to more individuals, Unistop Financial typically has a minimum of $100,000 as an entry investment.

Venture Capital

Investment in new, potentially high-growth, businesses alongside company management. Venture-capital financed companies may carry more risk than the other private equity segments due to the early stage of the business.

Growth Capital

Typically working in partnership with a founder or entrepreneur, the private equity investor supplies capital to help a company grow.

Buyouts

Investment in mature, proved companies, using a combination of debt and equity financing. This group is divided into small-, mid-and large/mega-cap buyouts.

Special Situations

Involves restructuring of companies both from a financial and operational standpoint and may involve the purchase of distressed assets or debt.

Primary fund investment

An investor makes a commitment to a private equity fund that, via a general partner, makes investments in companies. This supplies diversification of underlying holdings across the private equity portfolio.

Fund of funds

In this case, an investor makes a commitment to a vehicle or a fund that in turn makes commitments to individual private equity funds. These commitments are typically quite diverse, with investments across managers and portfolio companies.

Private Debt

Investment in the debt of private companies that provide fixed income returns with an illiquidity premium.

Secondary fund

In a secondary fund, the manager buys more mature or seasoned limited partnership stakes from other limited partners, often at a discount.

Co-investment

The investor makes an equity co-investment in an operating company, alongside the private equity manager, in a leveraged buyout, recapitalization, growth or venture capital transaction.