Illiquidity, as we noted in our last blog, has become a top-of-mind concern for private market investors. But letting anxiety about asset illiquidity determine your investment decisions risks missing out on the potential long-term returns available in private markets.
A better option: spread your capital to create a truly diversified portfolio that balances risk, returns and liquidity in line with your investment objectives and budget.
Alternative sources of diversification
Diversification, in the oft-quoted words of Nobel prize-winning economist Harry Markowitz, “is the only free lunch in investing,” a way to maintain or improve returns without taking on more risk. And the starting point for real diversification lies in the venture capital world, argues Divyesh Hindocha, a former Senior Partner with Mercer and current Treble Peak advisory board member.
During the long period of low interest rates and low inflation a mix of listed equity and bonds (sometimes referred to, mostly in the US, as the 60/40 portfolio) offered investors an attractive mix of capital appreciation, income and risk control. But the recent period of rising interest rates and inflation , and fear the trend could continue, has undercut that model.
In the hunt for new sources of risk-adjusted outperformance, investors have flocked into private markets. Yet the degree of real diversification on offer needs to be carefully considered.
Private equity has long been the most popular way for investors to allocate to private markets. However, PE as an asset class and major equity benchmarks have exhibited a correlation of around 0.7 over the past decade. Private equity funds ultimately rely on the listed market for success, both to buy assets and exit the investments. While private equity firms can provide value-additive changes to their portfolio companies, they remain hostage to the state of the listed marketplace to realise that value, diminishing some of the perceived diversification benefit. Also PE strategies can be leveraged, with recent increases in interest rates, what was a tail wind of declining interest rates is now a headwind.
Diversify through venture capital
For investors wanting real, not just statistical diversification, allocating to venture capital is likely to be a better option, with its opportunities to gain exposure to genuine new wealth creation through innovation, contends Hindocha.
We are, he says, in the midst of a new Renaissance , where an incredible amount of change is taking place in areas from artificial intelligence and digitisation to healthcare and energy. And the smartest people and best idea generation are happening in the start-up space.
“People are coming out with great ideas that offer different, disruptive ways of consuming, and addressing some of the biggest problems we face today, be it the climate crisis, sustainability, new energy sources, aging societies or governments under stress,” he says. “Through the venture world, they are providing solutions to the marketplace that either don’t exist, or that exist but can be achieved better or cheaper.”
There is risk, of course. Start-ups have significant failure rates. VC fund portfolios tend to be fat-tailed, with a skewed distribution between profitable investments, those that break even and others that lose money. “But is there that much more risk than investing in emerging or frontier market equities?” notes Hindocha.
With careful due diligence and smart fund choices, investors can minimise the risk they are taking on, he says. As can diversifying the number of VC funds they allocate to.
Not so illiquid
Illiquidity of VC investments is another commonly cited concern. Hindocha contends though that there is often less illiquidity than seen in many private equity funds.
The flood of money flowing into private equity in recent years, and limited opportunity sets, has resulted in record amounts of dry powder waiting to be drawn down for ever longer periods. In the meantime, investors can’t do anything with their commitments save park the money in a cash account or short-term gilts. Venture capital may be illiquid, but it will probably be put to work faster and thus come back out quicker, says Hindocha. “So it’s using an investor’s illiquidity budget more effectively than in the traditional private equity area.”
Hindocha also sees investment opportunities in the secondaries market and private debt. Investors that allocate capital to secondaries funds are likely to be investing in the up part of the curve, he says. “Capital will get to work quicker and the distributions will be returned a lot sooner. It’s still illiquid, but is likely to l be illiquid for a shorter period.”
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