Private market investments, like other alternative allocations, have helped asset owners diversify their exposures and boost overall returns, a welcome combination given the volatility of the global markets and unprecedented low interest rates.
But just as important as diversifying allocations among asset classes is having the right mix within a private markets allocation to fit an asset owner's long-term investment objectives and balance return vs. risk. Asset owners might be unintentionally falling short in their private markets portfolio composition.
Identifying the gaps between a portfolio's investment objectives and its current composition is more easily understood in liquid asset classes than in alternatives. Most institutional investors have excellent visibility into their public equity exposures by strategy, location, industry sector, company size and stage of development, as well as expected duration. This transparency allows asset owners and institutional money managers to rebalance their portfolios regularly to achieve their objectives.
Private markets portfolios rarely display this same level of transparency. Without this transparency, many private markets portfolios, even those of highly sophisticated investors, suffer from unintended allocations, exposures and correlations, as well as suboptimized return and risk. This isn't an acceptable outcome when private markets account for 15% or more of an asset owner's portfolio holdings. While visual flying rules might be acceptable when beginning a private markets program, investors should demand flight instruments once a portfolio is in place.
Understanding a private markets portfolio is more complicated than it might seem on the surface. It is not simply a matter of identifying private markets managers in which an institution wants to invest. It is also critical to assemble the pieces in a way that optimizes top-down portfolio construction. To adequately optimize, an asset owner must first obtain visibility into exposures and then should use advanced analytics to gauge risk and return and correlation of these exposures. Because private markets often contain blind pools, sporadic capital calls, unpredictable liquidity patterns, hidden leverage and custom strategies, it can be difficult for even the most sophisticated asset owner to stay abreast of their exposures and correlations.
Once an asset owner determines the true composition of its portfolio holdings, it can then use portfolio construction and risk management systems to optimize and rebalance the overall portfolio. A solid private markets system must include tools to track and analyze portfolios based on all factors, including strategy, subclass, vintage year, location, duration, leverage, industry sector and company size. Based on that analysis, it is then possible to create target portfolios whose potential risk- reward profiles would be better aligned with the portfolio's goals.
The transition to a target portfolio should be carefully managed. As existing investments reach maturity, asset owners can allocate capital to other strategies and subclasses so the portfolio maintains a target allocation over time. If there is a significant imbalance, asset owners can accelerate rebalancing by using the secondary market to reduce overweight positions while committing new funds to underweight areas.
It is essential for asset owners to bridge the gap between their current portfolio composition and their desired investment outcomes — a gap that will only widen over time if left uncorrected. Advanced analytics and deep market expertise can help close that gap.
Jeffrey Diehl is managing partner and head of investments at Adams Street Partners LLC, a Chicago-based private equity investment manager.
