Growing pains

Not all that long ago, private equity comprised only a tiny fraction of the overall portfolio held by most institutional investors. But as the sector has become more established, the asset class is attracting a larger share of the overall capital of many pension funds, endowments and high-net worth individuals.

Recently, the California State Teachers Retirement System (CalSTRS), the second-largest pension fund in the US, announced plans for an “unprecedented shift” in allocation, earmarking more money for higher-risk, higher-reward sectors from the $144 billion (€113.3 billion) in assets it manages. CalSTRS pushed its target for alternative investments, which includes private equity and hedge funds, up to 9 percent from 6 percent. The move will boost the organization's exposure to alternatives to the tune of $11.5 billion.

But as private equity matures, new challenges are facing advisors and investors as they chase the same kind of returns achieved in years past. With more investment choices available, and a growing sense that many of the larger funds will struggle to post the eye-popping returns they have recorded in recent times, matching an investor with the right mix of funds has become a more demanding task.

“It's not like it was 10 years ago when you were literally building a portfolio from scratch or there was very little in there,” says Mario Giannini, chief executive of Hamilton Lane, which advises several major institutional investors including the California Public Employees' Retirement System (CalPERS), the largest pension fund in the US. “You now have to figure out what's in the portfolio, what the return characteristics are, whether you are seeking something more or different, and how you are going to do that.”

How much investors need to diversify within the private equity asset class remains a tough question. And what exactly diversity means within a private equity portfolio is open to conflicting interpretations.

“What we're advising is that investors need to concentrate the portfolio more,” says Giannini, adding that he sees concentration as the foremost trend. “Stacking a portfolio with too many similar funds will lead to a “regression of the mean.”

“I think people have finally figured out that you can't take the public equity view of ‘I need 100 names,’” he says. “Within private equity, you don't need every group in the large buyout or middle buyout space. Having too many will drive returns down.”

There is no set formula which automatically strikes the proper balance of risk and return. “A lot of people are running around with an exact number of partnerships you should have in a portfolio to make it diversified,” says Christophe Rouvinez, a managing director at Swiss asset management firm Capital Dynamics who heads up portfolio and risk management. “There is no such number.”

Advisers point out that the level of diversity they recommend in a portfolio depends on the client and their appetite for risk, among other things.

“Private equity, unless you have perfect information about a market, is a game you should play on a diversified basis,” says Rouvinez, noting that he considers this especially true for new entrants to the asset class.

“On the other end of the spectrum, we have clients who have been investing in the industry for the last 20 years. Those people have the opposite problem. They have too many relationships,” with fund managers, says Rouvinez.

In cases like that, advisors insist, deciding which relationships are going to be the most lucrative going forward while maintaining balance within the portfolio is key. Rouvinez says: “That is a much more difficult task than trying to build up a balanced portfolio from scratch.”

While the private equity industry has grown rapidly, some things have been slow to change. Most investors and advisors still say they would like to allocate a significant portion of a portfolio to top-tier US venture capital funds, even though access to standout funds remains problematic and may be more difficult than ever today.

A lot of people are running around with an exact number of partnerships you should have in a portfolio to make it diversified… There is no such number

Christophe Rouvinez

If possible, Rouvinez says he would have many of his clients place between 15 and 25 percent in top US venture funds. “We only recommend people invest in venture capital funds provided they get access to the best funds. That's a major change from what used to happen.”

Hamilton Lane's Giannini concurs. “If you are not in the top funds in venture capital, you shouldn't be in that asset class by and large,” he says.

Some advisors say that anyone promising new entrants to private equity a significant presence in top VC funds will most likely be unable to deliver. So, what is an investor without unfettered access to the best VC fund managers to do? “You put what little money you can with those guys, even if it's only a little bit, and test the water with the next generation,” Rouvinez says, while restricting the overall allocation within the sector.

Hamilton Lane's Giannini and Capital Dynamics' Rouvinez both advise keeping a venture capital allocation light unless the money is going into the top funds. But both also say flexibility is vital, so that when an opportunity arises, there are funds available to chase it.

“Our view on venture capital is that you don't set an allocation. You have to be much more opportunistic and can't say, ‘I need 15 percent,’” says Giannini, who also advises caution when it comes to setting targets for emerging markets. “We haven't said don't do them, but the idea of having a set allocation in emerging markets like people do in public equity doesn't strike us as the right approach.”

Some advisers also warn against any attempt at “timing the market,” in favor of spreading a private equity portfolio evenly among vintage years.

“It's a bit like waiting for a bus,” says Guy Fraser-Sampson, the author of Multi Asset Class Investment Strategy a book about strategies for investing in alternative assets. “You wait for an hour and then four come along all at once.”

“By the time you think a segment is hot, it's probably no longer hot,” says Rouvinez. “When you give your commitment, you are going to be after the wave, it's going to be too late and it's going to be bad for your returns. What we would recommend to clients is to be invested in a good mixture of the various styles at every single point in time.”

While private equity investors, especially new ones, should proceed with caution when it comes to certain sectors, there are mainstays, according to advisers and industry observers.

Fraser-Sampson, whose book recommends investors place 25 percent of their capital in private equity, says the right mix of US venture, European buyout and US buyout is key.

“We've told clients they cannot be without large buyouts,” Hamilton Lane's Giannini says.

When you give your commitment, you are going to be after the wave, it's going to be too late and it's going to be bad for your returns. What we would recommend to clients is to be invested in a good mixture of the various styles at every single point in time

Christophe Rouvinez

That said, some advisors say they recognize that the days of big buyout funds posting returns in excess of 30 percent have passed and that fund managers recognize this and are managing investor expectations accordingly. They say investors and their advisors need to take a hard look at the upper end of the buyout market and decide how much capital they want to place there.

“Five years ago we were massively overweight on the big end and have now brought that down a bit on the theory that that end is a little more efficient. It's not as obviously screaming ‘buy’ as it was,” says Giannini.

Advisors say the definition of a good portfolio is that it is finely tailored to the needs of investors that are in many cases increasingly sophisticated. Gaining access to established fund managers with proven track records remains key, but so is identifying the next stellar performer.

“If you're looking to invest $10 billion in private equity, there is a very different portfolio construction [involved] than if you are looking to invest $100 million,” says Giannini.

Increasingly, investors want to get a much better grasp on the quantitative aspects of the private equity portion of the portfolio so they can better explain how the asset will perform over time and include numbers to that effect in their annual reports, according to advisors.

“Across the board clients are getting more sophisticated, and they want to be able to better forecast or have a better insight about how assets might develop over time,” says Rouvinez. “Private equity is no longer one of those small pockets where you just put in a little bit of money and if it does great, that's great – and if it doesn't do great, it was only a bit of money. It has become an established asset class.”

The bottom line when developing a portfolio remains the same. Rouvinez makes it sound deceptively simple: “When we look at investing with people, we always try to find the right people, who have the right strategy at the right point in time.”