Private equity is an integral part of an institutional portfolio’s alternative asset allocation. This is owing to the fact that private equity is complementary to traditional asset classes and has been demonstrated to be accretive to total returns while providing significant diversity from public equities and fixed income markets. When private equity is integrated into a standard portfolio, however, several distinctive characteristics can provide major hurdles to asset allocation decisions.
The projected return and risk of an asset class are two important factors to consider when making asset allocation decisions. Time-weighted returns are used in public markets for a certain holding term, with the premise that no transactions occur throughout the investment period. Private equity investment performance, on the other hand, is generally calculated using an internal rate of return, which accounts for all cash flows from the venture’s start. This may result in a misalignment in the evaluation time horizon between a private equity investment and more traditional assets for an investor. Using interim period volatility to assess the risk of private equity, as it is for other liquid or market-traded assets, can also be problematic. Because its performance is based in part on the values of underlying firms, which tend to respond slowly to market information and can be artificially smoothed, the private equity market may look less volatile than the public market for a short period of time.
Several approaches for estimating private equity volatility have been created by “unsmoothing” appraisal-based returns utilizing a large pool of assets representing various private equity strategies or subclasses. Despite the fact that various methodologies may provide somewhat different estimates, they all provide useful information about how different sectors of the private equity markets fluctuate over time and their short-term risk characteristics. Due to the lack of a broad-based private equity benchmark, an individual investor’s private equity portfolio is likely to differ from the market in terms of the subclass, geography, fund size, sector exposure, vintage year, and other factors, and they would each face different investment opportunity sets when making a new capital commitment. Investors in private equity typically cannot move in and out of their stakes regularly without incurring considerable transaction expenses after they have made a commitment. As a result, investment and allocation decisions must increasingly be based on the economic worth of the investor’s existing private equity obligations, as well as the dispersion of their end outcomes once these commitments have been held to maturity or fully liquidated.
Despite the high cost of purchasing and selling pre-existing private equity assets, secondary market transactions have increased significantly, owing to investors’ increasingly active attitude to managing their private equity portfolios.
LPs may utilize the secondary market to:
- Increase or reduce exposure to certain market sectors as a result of a change in their investment strategy or economic condition.
- Manage unforeseen risks as their holdings develop.
- Simply obtain liquidity from their existing assets. Secondary sales, which can include a huge portfolio of assets, are another way for private equity asset managers to generate liquidity, return cash to clients sooner, and maximize portfolio performance.
We’ve seen an increase in GP-led transactions that are driven by a desire to not only provide liquidity to existing LPs, but also to realign the interests of various stakeholders, bring in new capital, and allow the sponsor to manage selected assets for longer periods of time in order to create more value. Whatever the incentive for secondary market participants, the capacity to pick transaction assets and the ability to evaluate their risk-adjusted return potential during the ensuing holding term are key to success.
Fund performance tends to rise, not reduce, for funds older than five years.
The cross-section variation of funds is used to estimate the factors of future fund performance. Future fund performance is predicted by a number of market-wide and fund-specific characteristics, including liquidity created to date, prior fund performance, dry powder (at both the fund and market-level), public market returns, credit spreads, and so on. However, the key parameters differ for buyout and venture capital funds, and they might change throughout the course of a fund’s existence.