Private equity investors have a vast universe of investment opportunities – from angel financing to leveraged buyouts. They can invest in primary funds, buy secondary interests in existing funds or invest directly into companies. They can build up global programmes or focus on certain regions. Since the universe of investment opportunities is so diverse, the asset allocation has a profound impact both on the risk and the return of a private equity portfolio.
RISK AND ROBUSTNESS
During recent years, asset allocation models that focus on risk and disregard returns have attracted great interest, since they are more robust than traditional models. Estimating returns from past samples can lead to erratic results – whereas focusing on risk generally produces more stable models.
1. The risk-weighted asset allocation
Risk can be defined in numerous ways. The simplest method is to use volatility within a certain window; unfortunately, the size of the window heavily impacts the results. For the purposes of this article, we will work with a definition of risk that does not depend upon the choice of a window but that gives more weights to recent events: the RiskMetrics model (although we modified it to be more sensitive to negative shocks (losses) than positive shocks (gains) in a way that is analogous to the semi-volatility or downside volatility).
2. Market-weighted risk contribution model
In private equity, the different asset classes represent different geographies, strategies and investment styles. And they are not comparable in terms of market sizes: for example, the US buyout market is much bigger than the European venture capital market. Instead of allocating the portfolio in such a way that each asset class contributes the same amount of risk, we allocate the risk according to the market weight of each asset class. We call the resulting portfolios market-weighted risk contribution portfolio (MWRC). In a market-weighted risk contribution portfolio, an asset class with a larger market will have a larger allocation. Additionally, a higher risk in an asset class will lead to a reduction of the allocation, similar to ERC portfolios.
Market weighted risk contribution portfolios offer a sound asset allocation framework for private equity. The robustness of the solution allows investors to move from a theoretical setting to practical investment plans by committing accordingly. And the methodology enables them to adapt existing portfolios to the market environment by incorporating risk facts and information about the size of the investable market.
Philippe Jost is a Vice President in Solutions at Capital Dynamics, focusing on Portfolio and Risk management, while Ivan Herger is a Director and Head of Solutions, which includes Portfolio and Risk Management and Structuring