“I wish it need not have happened in my time,” said Frodo.
“So do I,” said Gandalf, “and so do all who live to see such times. But that is not for them to decide. All we have to decide is what to do with the time that is given us.”
The Fellowship of the Ring, J.R.R Tolkien
With the economic impact of COVID still lingering and the war in Ukraine grinding on, we live in uncertain times.
While the circumstances of each disruption is unique, the ubiquity of disruption is not. If you’re in your fifth decade, you’ve lived through the European Debt Crisis, the Great Recession, the Dot-Com bubble, the Savings & Loans crisis and the OPEC oil shocks, to name just a few.
In a world of uncertainty, how does one start to think systematically about building an investment portfolio, one that is resilient to inevitable uncertainty?
There is a story of a farmer who went out to plant seeds and, as they were scattered, he realised too late that some had fallen along the path and were eaten by birds. Some fell on rocky soil, and being too shallow, grew early and were burnt by the sun, while some again fell in the untilled earth and were choked by thorns. Yet, to his relief, still others fell on good soil and produced a crop ‘sixty…times what was sown’.
One might ask our farmer, “why didn’t you just plant all your seeds in the ‘good soil’? Surely, then your harvest would have been more”. In retrospect, this seems like a good point. Yet, as the farmer knows, at the time of planting, it is not always so obvious where the ‘good soil’ may be found.
By scattering more widely, the farmer lowered the risk against the unexpected. What produces bounty one year, may cause famine the next. While some farmers undoubtedly made more one year by high concentration, a wise farmer cares about avoiding famine not just this year, but every year from here on out.
What does this all have to do with building an investment portfolio and considering an allocation towards private markets? Well, as investors, we are all the farmer, considering where to scatter our investments.
There is no single or right answer about where to scatter, that will depend on your personal objectives and tolerance. However, you can build a framework for thinking about how you build your wealth. In this article, we consider how you might start to think about an allocation towards private markets and if it is right for you.
Factors to consider when determining the appropriate types of private markets exposures
Let’s start off with the factors investors need to consider when deciding what type of private market exposure they should include in their portfolios.
Like most investment-related decisions, diversification is an important consideration. While an allocation to private markets is likely to provide additional diversification benefits to a traditional portfolio of listed shares, bonds and cash, the magnitude of the diversification benefits is going to depend on how diversified that private markets allocation is. Ideally, investors should diversify their private markets exposures across different asset types, investment styles, managers, geography, industries/sectors etc.
Total portfolio consideration (income versus capital growth)
Investors need to consider the role that the private markets exposure will play in their total portfolio. For example, there is no point getting an exposure to income generating private market exposures if it means the expected total return of the portfolio falls short of the target return objectives. Equally, a private markets exposure that focuses on capital gains rather than income is not necessarily desirable if the total portfolio falls short of its annual income yield target.
Investors need to understand the return characteristics of the private markets exposures they are considering and how they will fit in their total portfolio. In broad terms, private markets exposures that are more capital gains oriented are more likely to replace the growth assets exposures of a portfolio (e.g. listed shares, property and infrastructure). While the more income oriented private markets exposures are more likely to replace the defensive assets exposures of a portfolio (e.g. fixed income and floating rate note-type securities).
The universe of private markets investments spans across the entire risk spectrum. This ranges all the way from government bond-like core infrastructure, (such as toll roads with highly visible contracted revenue streams and in-built inflation increases that are backed by a government), to speculative venture capital investments, which are effectively investments in unproven business concepts that are generally not yet generating any revenue. Then there is also every combination of risk and return profiles in between those two extremes.
In considering the risk spectrum of private market investments, investors will need to weigh up the risk of falling short of their investment return objective versus the risk of capital losses, since investment with higher expected returns will also have higher expected capital losses and vice versa.
Some investors may also wish to tailor the exposures in their portfolio according to their investment outlook. For example, an investor may believe (for whatever reason) that high levels of inflation is likely to be sustained over say the next 10 years. Such an investor is likely to want to tilt their private market exposures towards assets that benefit from inflation. Similarly, an investor may believe that the economy of Country A is going to perform much better than Country B and may tilt their portfolio to Country A to benefit from that belief. However, investors should take into consideration any adverse impact such tilts will have on the diversification of their portfolio and weigh up this risk in their investment decision.
Factors to consider when determining how much private markets exposures is appropriate
Now you know a little more about the factors that may influence your decision on the type of private market allocation, it’s time to focus on the amount. How would you go about considering how much to invest in private markets?
As noted earlier, even the response to the question of ‘how much private markets exposure is appropriate’ needs to consider diversification. Except in very specific and extreme circumstances, it is highly unlikely that 100% of an individual investor’s portfolio should be comprised of private markets funds. As such a portfolio will not be as diversified as a portfolio with exposure to listed market assets.
An investor’s liquidity need is probably the most important factor to consider when determining how private markets investments should be included in a portfolio. This is because private markets exposures are illiquid. Investors should be investing in private markets funds with the understanding that private market assets do not share the level of liquidity that listed shares do. In listed markets investors can buy and sell whatever dollar amount they want at any time during the working week, alternatively in the world of private markets it may be 7 to 10 years before they get their invested capital back.
Given the illiquid nature of private markets, investors should ensure their total portfolio has sufficient income and/or cash exposures to meet their regular liquidity needs. There should also be sufficient liquid assets that are able to be sold for unexpected needs or to top up the cash exposures as they are used (it also wouldn’t hurt to factor in a buffer for those unexpected needs).
While there are mechanisms for liquidating private markets exposures, they are very expensive and should really only be considered as an absolute last resort. Instead, it is preferable for investors to make sure that they determine the appropriate amount of liquidity they require from the outset and only invest in private markets up to a level that does not jeopardise their liquidity requirements.
The life of a private markets fund is generally in excess of 10 years. While the private markets manager will exit some investments before the end of the 10-year life span and pay out distributions, the timing and magnitude of those distributions are not guaranteed. Investors with short-term investment objectives should probably avoid investing any money they will believe they will need to call upon prior to the end of the 10-year life of the private markets fund.
‘One portfolio to rule them all’?
If you were to ask us “where is the good soil?” Unfortunately, the answer is ‘it depends’. There is no one portfolio that fits all, nor a clear type or amount of private market exposure. It will depend on your individual circumstances, tolerance and objectives. For that, you should speak with your financial planner or adviser.
What we can say is that many institutional investors, such as Australian Superannuation funds, are using private market funds to find diversification and potential outperformance. For example,
AustralianSuper announced last year its plans to double its private equity exposure over the next five years. The Future Fund has already increased its private equity exposure to $34.5 billion or 17.5 per cent of its portfolio.
Hostplus, which posted positive returns in 2021 despite economic uncertainty, noted to the SMH that:
“Being overweight in unlisted assets such as infrastructure and real estate had provided protection against inflation”
“One of the benefits of unlisted assets is that they’re not subject to the whims of the volatility of equity markets.”
“Super funds who can’t tolerate the illiquidity of real estate, of infrastructure, they choose not to invest there, they suffered a lot. Our belief is [in] active management and diversification - so as many asset classes as possible to spread the risk - and in particular, we believe in mid-risk assets, unlisted infrastructure and unlisted real estate, and those performed particularly well.”
Is this right for you? Only you can decide. Even if you would like to increase your exposure, you’ll need to consider the problem of getting access to top-tier managers along with timing issues since managers typically raise episodically and for discrete amounts. This is where Reach Alternative Investments helps. We provide our community with access and help soften some of the harder edges of private market investments. While we cannot tell you whether private market exposure is right for you, we can provide you with access if you decide to move ahead.
That’s not all she wrote…
That brings us to the end of our four-part education series on private equity. But the journey is not yet over. Now that you have learned the basics of private equity, we encourage you to keep an eye out for future series further exploring private equity and other areas of private markets.
If this education series has been helpful, please share it with your friends and If there is something that you would like to see us write about, please let us know below.
For more information about our available private equity funds, please visit our private equity funds page.