The second month of 2018 shook many investors to the core. Headlines screamed “correction,” “downturn,” “volatility,” and other words that strike fear in the hearts of market-watchers young and old.
While there remains debate about what caused the shocks in the equity markets in early February, one thing we can all agree on is that portfolio diversification is key to helping investors successfully navigate market volatility. If the financial crisis of a decade ago taught us anything, it is that the traditional 60/40 stock and bond asset allocation model isn’t strong enough, in the short term, to weather catastrophic market conditions.
Private equity, which tends to have limited correlation to stocks and a low or even negative correlation to bonds, can provide much-needed diversification to help investors withstand volatility.
The Cambridge Associates U.S. Private Equity Index, a benchmark measuring U.S. private equity performance, outperformed the S&P 500 Index and the Bloomberg Barclays Government/Credit Bond Index with higher net returns over the 10-year and 20-year periods ending Sept. 30, 2017[i].
Adding private equity to investment portfolios can potentially mitigate risk and deliver a steady stream of risk-adjusted returns, but as I discussed in a previous ThinkAdvisor column, private equity is a broad asset class that includes a wide variety of investments — all carrying different levels of risk.
While research-and-development and startup company investments fall under the “private equity” label, these companies either don’t have a product to sell, or have not yet yielded profits or cash flow. As a result, they are risky investments, and investors may have to wait years before they begin receiving any returns on seed capital in R&D companies and venture capital in startup companies.
Indeed, the 2018 Preqin Private Equity & Venture Capital Report revealed that 29% of institutional investors surveyed by Preqin in December 2017[ii] stated venture capital investments fell short of expectations during the previous 12 months.
On the other hand, middle-market companies that already produce income and cash flow can be considerably less risky for investors, and may be able to begin delivering regular distributions following an investment.
Companies that already have a solid infrastructure in place, and have a proven track record of generating income, often have a much greater chance of providing returns, making them significantly less risky as investment targets than their R&D and startup counterparts.
After all, capital that will help grow a business that is already demonstrating success and creating profits and revenue typically offers more promise than capital that is intended to help a company with no cash flow or income create the infrastructure to sell a product that’s never been sold.