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.
If middle-market, income-producing companies operate in industries which have historically not suffered a decline in consumer demand during recessions, and are difficult for newcomers to enter, then they may offer more promise to investors.
A growth-focused company whose performance isn’t tied to what happens in the equity or bond markets, and that isn’t as susceptible to disruption, could be considered a less risky investment to offset equities and bonds in a portfolio — especially if the operating partners or management team that helped get the company to its present growth stage will stay on and/or retain a minority ownership stake post-investment.
Advisors can help their clients diversify their portfolios ahead of potentially more volatility like we saw in February by working with them to identify promising private equity investment opportunities that can offset equities and fixed income in their portfolios.
I’ll leave you with a research finding from the 2018 Preqin Private Capital & Venture Capital Report — 95% of institutional investors surveyed by Preqin in December 2017 felt their private equity investments met or exceeded their expectations during the previous year[iii].
[i] The Cambridge U.S. Private Equity Index generated annualized returns of 9.66% over the 10-year period ending Sept. 30, 2017, compared to the S&P 500 Index’s 7.44% returns and the Bloomberg Barclays Government/Credit Bond Index’s 4.34% returns over the same period.
The Cambridge U.S. Private Equity Index also generated annualized returns of 12.16% over the 20-year period ending Sept. 30, 2017, compared to the S&P 500 Index’s 7% returns and the Bloomberg Barclays Government/Credit Bond Index’s 5.18% returns over the same period. Data was published in “US Private Equity Index and Selected Benchmark Statistics,” a report published by Cambridge Associates on Sept. 30, 2017.
[ii] Of the institutional investors surveyed by Preqin in December 2017, 29% stated that venture capital investments have fallen short of expectations. This finding was published in the “2018 Preqin Private Equity & Venture Capital Report.”
[iii] Of the institutional investors interviewed by Preqin in December 2017, 95% felt their private equity investments met or exceeded their expectations in 2017. This finding was published in the “2018 Preqin Private Equity & Venture Capital Report.”
Jeffry Schneider is CEO of Ascendant Capital and a Founding Principal of Ascendant Alternative Strategies. Mr. Schneider brings over 25 years of financial services industry experience and an extensive network of public and private pension funds, family offices, and global financial services firms.