How to Structure Your Portfolio with Private Equity Investments

Building a well-rounded investment portfolio is critical to achieving strong returns to meet your investing goals. Just as you wouldn’t rely solely on one type of vegetable or protein, relying on a single type of investment can leave your financial future lacking essential nutrients. This blog will walk you through the basics of portfolio structuring, introduce the principles of portfolio theory, and dive into how to integrate private equity investments into your portfolio to achieve your investing goals.

What is Portfolio Theory?

Modern Portfolio Theory, developed by Harry Markowitz, is a fundamental concept that helps investors understand the balance between risk and return. It suggests that by diversifying investments across different assets, you can optimize your portfolio’s performance. The key idea is to combine assets in such a way that they collectively offer the highest possible return for a given level of risk, represented visually by the “efficient frontier.”

Notice in the chart below that the assets that fall below the efficient frontier lack a higher expected return for a greater amount of risk taken.

The chart below with risk on the x-axis and return on the y-axis illustrates this. At one end, you have money market instruments with low risk and modest returns. On the other end, you have emerging markets, which offer higher potential returns but come with significantly higher risk. As risk increases, the incremental returns tend to diminish. This principle underscores the importance of diversification: spreading your investments across various assets to achieve a balance that aligns with your financial goals.

Typical Guidance on Portfolio Structuring

A commonly accepted strategy in portfolio structuring is the equity/fixed income mix, tailored to an investor’s age and risk tolerance. Younger investors typically have a higher allocation to equities, given their potential for higher returns and the ability to weather market volatility over time. As investors approach retirement, the mix shifts towards fixed income to preserve capital and provide more stable returns.

For instance, a traditional guideline suggests a 60/40 split between equities and bonds for a balanced portfolio. However, this allocation evolves, increasing the bond portion as one nears retirement to mitigate risk. This strategy aims to strike a balance between growth and stability, ensuring that your portfolio can support your financial needs throughout different life stages.

Adding Private Equity

Private equity (PE) offers a unique avenue for enhancing your portfolio’s performance through investments in non-publicly traded companies. Let’s explore three main types of PE investments: venture capital, buyout funds, and growth equity.

Venture Capital (VC)

Venture capital involves investing in early-stage companies with high growth potential. These startups often bring innovative solutions and disruptive technologies to the market. While VCs can reap substantial returns, they also face significant risks, as many startups fail to achieve commercial success. Companies like those on Linqto primarily fall into this category, presenting opportunities for high rewards in exchange for higher risks.

Buyout Funds

Buyout funds focus on acquiring established companies, often leveraging debt to finance the purchase. These investments typically involve mature businesses with steady cash flows. The goal is to improve the company’s value through strategic and operational changes before eventually selling it for a profit. Buyout funds offer a balance of risk and return, sitting between the high-risk VC and lower-risk public equities.

Growth Equity

Growth equity is the middle ground between venture capital and buyout funds. These investments provide capital to relatively mature companies looking to expand or restructure. Growth equity investors partner with company management to drive growth, often without taking full control of the business. This type of investment is less risky than VC but still offers attractive returns compared to traditional public market investments.

What the Research Says About Adding PE to Your Portfolio

Research, including insights from the Neuberger Berman report, highlights several benefits of incorporating private equity into a diversified portfolio. Despite the smaller allocation typical for individual investors, PE has consistently outperformed public equities over long periods while offering valuable diversification.

Key Advantages of Private Equity:

1. Information and Control: PE managers often have deeper insights into their investments and more control over strategic decisions, enabling value creation through operational improvements.

2. Timing Flexibility: PE managers can carefully time their entry and exit from investments, unlike public market managers who may face more pressure to buy or sell based on market conditions.

3. Unique Opportunities: Many private companies don’t have public equivalents, offering distinct investment opportunities that can enhance portfolio diversification.

In the Neuberger Berman report, several critical points emphasize the value of adding private equity to a portfolio:

Performance and Diversification: Private equity has a history of outperforming traditional assets over time. According to the report, private equity has consistently delivered higher returns compared to public equities, with lower correlation to public markets. This lower correlation means that private equity can act as a buffer against market volatility, providing a stabilizing effect on the overall portfolio.

The chart below illustrates this.

Shrinking Public Markets: The report highlights a significant trend: the shrinking universe of publicly owned companies. Over the past 18 years, the number of U.S. public companies has declined from around 5,000 to approximately 4,300, while the number of private companies has grown significantly. This shift underscores the growing importance of private equity as a source of investment opportunities.

Broadening Opportunity Set: Private equity is no longer limited to leveraged buyouts of low-growth, asset-intensive businesses. The opportunity set has expanded to include early, mid-, and late-stage companies across various sectors, including high-growth technology firms. This diversification within private equity itself enhances the potential for attractive returns.

Advantages Over Public Markets: Private equity offers several advantages over public market investments. PE managers often have deeper access to information and more direct control over the companies they invest in. This control allows them to implement strategic and operational improvements that can drive value creation. Additionally, the ability to time entry and exit points provides a significant advantage over public market investors who are subject to market timing constraints.

Public Comparable Discount: While private equity investments are less liquid than public equities, this illiquidity can actually be a benefit. Because investors need to lock up their money, they will demand a discount on the multiple. Investors willing to lock up their capital for extended periods are compensated with higher potential returns.

Risk Mitigation: The report also notes that private equity’s unique characteristics can help mitigate risks associated with public markets. For example, during periods of market stress, private equity investments are less likely to experience the same level of volatility as public equities. This stability can provide a valuable counterbalance in a diversified portfolio.

Considerations

Diversification

The higher the risk associated with an investment, the greater the need for diversification. Venture capitalists, for example, spread their investments across hundreds of startups, knowing that many will fail, but the successes will more than compensate for the losses. In contrast, the S&P 500 is heavily weighted towards its top 5 companies, which make up a significant portion of the index’s total market value.

Risk Management

Buyout funds typically invest in a smaller number of companies compared to venture capital, offering a middle ground in terms of diversification and risk. This principle shows that as the risk level of your investments increases, so too should the number of individual investments to mitigate that risk effectively and achieve higher returns.

Conclusion

Structuring a robust investment portfolio requires a careful blend of different asset classes to balance risk and return. You should always understanding and apply the principles of portfolio theory, incorporating traditional assets like equities and fixed income, and exploring the potential of private equity, investors can create a diversified and resilient portfolio. Whether it’s the high-risk, high-reward nature of venture capital or the more stable growth opportunities in buyout funds and growth equity, private equity offers a valuable component to consider in your investment strategy.