How should we think about diversification within private equity?
Private markets are often lauded as being excellent portfolio diversifiers for investors seeking alternative drivers of risk and return. But the diversification possibilities that exist within the private market asset class tend to receive less attention.
Private equity (PE), for instance, covers a range of investment vehicles and opportunities. Funds in this space are not all alike. They all have different risk-reward profiles, i.e. different return expectations and different loss rates. Below are just some of the characteristics we can use to distinguish one fund from another:
Stage of investment - Venture capital, growth, buyout, credit etc.
· Fund size - Different strategies will target the lower mid-market, large and mega spaces, dependent upon the fund size. Each of these depicts a different risk-reward profile.
· Investment style - Is the fund oriented towards growth or value?
· Geographic focus - Some are global in nature, while others target specific regions.
· Sector specialism - There are PE funds that target individual sectors, and those with a generalist strategy.
Such varied characteristics offer potential PE investors or limited partners (LPs), many different avenues for diversification.
A blended approach
For many LPs, getting the right blend of private equity assets is crucial. Structuring a portfolio, choosing managers, carrying out due diligence and allocating capital are not simple tasks, but they are essential. Patience and expertise are required in abundance.
And for each type of PE fund, there are different points to consider. More predictable return profiles might be found among large-cap funds, but such funds might also have less potential for outperformance.
On the flip side of the coin, funds that focus on the small and lower mid-market might have more potential to generate returns over and above those of the wider market. Such a fund is likely to display higher levels of volatility than its large cap-focused peers, however.
Striking the right balance
Making a commitment as an LP means that your capital will be locked up for a long time (often ten years). It is essential to have a deep understanding of the strategy that spans team set-up, performance and a bottom-up understanding of the portfolio.
Against the background of a fast-evolving private equity landscape, one way to access a very broad opportunity set is to take a multi-manager approach.
