Private equity investing has become very popular in recent years.
This is due to three main factors: greater acceptance as a legitimate asset class by the majority of sophisticated investors; modern portfolio theory, which postulates that adding asset classes that are not highly correlated to a portfolio lowers risk and provides superior risk-adjusted returns; and rebalancing, which has increased allocations to private equity investments as the recent strong U.S equity markets have resulted in shrinking allocations (in percentage terms) to other asset classes.
These factors have resulted in record inflows to private equity investment funds, with investments totaling more than $85 billion in 1998, a record increase over the $55 billion raised in 1997. (For purposes of this article, we will define private equity as encompassing both venture capital and leveraged buyout funds.)
Investing in private equity is not without its hazards, of course. Careful consideration must be given to the risks involved, which include:
* Illiquidity. Investors are locked into illiquid partnerships for long periods of time, typically eight to 12 years. A secondary market where investors can sell their interests is developing, but is still in its infancy.
* The J-curve effect. Returns usually are negative in the first few years of a partnership because positive results are not visible until investments mature several years down the road. The phenomenon is named for the typical pattern of returns -- first negative, then rising -- which, graphed over a period of years, resembles a 'J.'
* Poor manager selection. The expertise and time required for performing strong due diligence might not be available, leading to poor manager selection. One's choice of managers is very important because of the wide disparity among private equity fund returns, as shown in Exhibit 1. The far right column shows the spread between a manager just making it into the top quartile and one just falling into the bottom quartile of his or her peers. One can see that for stocks and bonds, there's not much difference between a top quartile manager and a bottom quartile manager. In the private equity sector, however, the huge spreads make manager selection much more important than it is in traditional asset classes.
* Vintage year risk. "Vintage year" refers to the year in which a fund was raised. This is the risk of poor or unlucky timing; that is, committing to a fund during a year that turns out to be a lousy starting period for venture capital or buyout funds. Such risk also could include not allocating capital during a particularly attractive year. It is difficult to determine in advance which years eventually will prove to be attractive vintage years.
* Uncertain timing of cash flows. The timing of both capital calls (investors' contributions into a fund) and payouts to investors is uncertain, and both occur over a period of many years. This should not be a serious problem unless illiquid investments represent a large portion of the overall portfolio.
This uncertainty does, however, cause a discrepancy between the amount committed and the actual dollars invested.
Commitment vs. investment
When an investor decides to commit a certain dollar amount to a private equity fund, the fund "calls" or takes those dollars over a period of several years as investment opportunities arise. Before partnerships can call the entire amount, they often start making distributions back to investors, as a result of earlier investments. Thus, for most of the life of a private equity partnership, dollars actually invested fall short of dollars committed. Exhibit 2 illustrates the difficulty Vassar has had increasing its allocation to private equity. Six years ago the college had 1.5% of its portfolio invested in private equity. Since then, Vassar has committed an additional 11% to buyouts and venture capital, but the actual allocation has risen only to 3.9%. A rough rule of thumb is to commit 50% more than your desired investment and twice as much if investing in a fund of funds.
An investor can take several actions to reduce the risks involved in private equity. One should:
* Make sure the investment policies are sound. All decisions should be driven by a written policy that ideally includes specific rationales for incorporating private equity into the portfolio. Then implement that policy wisely and efficiently.
* Perform strong due diligence, or hire someone to do it for you. Such research and analysis should include a close look at such factors as the people who run the fund, their investment philosophy, the investment process, the track record and the terms of the agreement. Because of the wide disparity between good and bad private equity managers, time and money spent on due diligence now is likely to provide a large payoff later.
* Take the long-term view. A commitment to private equity should be a long-term strategic decision, not a short-term tactical one. It is virtually impossible to market-time one's entrance to, or exit from, this asset class.
* Use a fund-of-funds manager. This type of investment can give the investor a core holding while mitigating several types of risk: manager risk, because several different managers are included; due diligence risk, because there's another level of oversight; and vintage year risk. Fairly high minimums make diversification among various private equity funds difficult unless significant capital is allocated. But investors committing more than $25 million should consider building vs. buying their private equity portfolios. This approach requires greater effort and coordination but often results in lower overall fees and a higher level of knowledge about the asset class.
Vassar has been investing in private equity for 11 years, with the goal of increasing returns and reducing risk. The college now has 3.9% of its endowment invested in private equity and has been trying to reach its policy allocation of 7%, but investments have been so successful that managers have been returning money to the college faster than it can be reinvested. Unlike virtually every other asset class, higher returns from private equity do not always translate into a growing proportion of one's portfolio because gains often are recognized and paid out to the investor around the same time.
Has Vassar succeeded in its goal of increasing returns and reducing risk? The college has earned 31% on its private equity holdings for the five years ended June 30. This has boosted the endowment's return slightly and reduced volatility because private equity returns are not highly correlated to the endowment's other holdings.
Jay A. Yoder is director of investments at Vassar College, Poughkeepsie, N.Y. Barry H. Colvin is director of research at Asset Consulting Group, St. Louis.