Defined contribution plan sponsors know full well the challenges they confront as they seek to provide investment options to their participants that can generate higher and more consistent levels of return in today's low return and volatile investment environment. The role for alternatives, including private equity, in helping them to meet those challenges is well documented for defined benefit sponsors, and will continue to grow in importance for defined contribution plans.
Before discussing the mechanics of implementing private equity in a DC plan, it is worth looking at the fundamental rationale for doing so, namely, the impact of private equity on portfolio efficiency and the ability to generate sustainable alpha.
Portfolios that include private equity in their asset mix have the potential to generate a higher level of risk-adjusted returns relative to those consisting of mainly public equities and bonds. The result is a more efficient overall portfolio.
Private equity's main contribution to the efficient portfolio comes from its lower level of correlation to those traditional asset classes. For example, the correlation between the Preqin Private Equity Committed Capital index and the MSCI World index from December 2000 to December 2011 amounted to 75.7%.
If one separates alpha from beta, the portfolio efficiency benefits resulting from adding private equity to a traditional asset mix can be further understood. Specifically, it is worthwhile looking at how a private equity fund investor approaches diversification when constructing and managing a portfolio.
At the same time, it is also important to note that these benefits do not apply to all private equity investors to the same degree. In order to optimize the benefits of the asset class it is useful to think in terms of gaining exposure to the “best” (top quartile) private equity investments by picking the best private equity managers. This achieves not only greater diversification due to lower correlation to other asset classes, but also adds alpha to the overall portfolio. Simply put, in private equity maximizing risk-adjusted returns is highly dependent on successful manager selection.