The core of your portfolio is invested in a globally diversified portfolio of low-cost index ETFs. Maybe you also have some active equity funds from a manager with a great track record, or active bond funds that can add some extra income to your portfolio by taking smart risks on corporate and high-yield issuers. You have a classic core-satellite portfolio, the kind of exposure that serves many investors well.
But your advisor reaches out to you and says that something’s missing, that you have the potential to do even better if you were to add private equity. As firms are increasingly able to access capital in the private markets, they’re waiting longer and growing larger before they go public. Many are choosing not to go public at all. Exposure to private equity can enable investors to benefit directly from that growth outside the public markets.
Getting the timing right
It’s a conversation that more and more investors are having as the private equity market grows and more options become available to investors. But with interest rates at their highest level in a generation, and many economists expecting them to stay elevated for an extended period, is now a good time for exposure to private equity? Won’t the higher borrowing costs and discount rates of the current environment diminish returns from private equity going forward?
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That might be true for some private equity managers who rely on cheap leverage to add value. But research suggests that leverage has diminished as a factor in the value generated by private equity. A 2022 analysis by researchers from the University of North Carolina found that only 8% of private equity returns were attributable to leverage from 2008 to 2018. The remaining 92% are attributed to operational improvements within the portfolio companies (50%) and valuation expansion (42%). Notably, leverage was historically cheap through much of that period. This low contribution to private equity returns from leverage is a major change from the past. The researchers found leverage accounted for more than half of private equity returns from 1984 to 2000.
The best private equity managers have the potential to outperform even during periods of high interest rates. They can improve their portfolio companies’ business models to help add enduring value that is resilient through rate-tightening cycles. To give yourself the best chance for success in private equity investing, consider an approach that programmatically invests with a proven manager across multiple vintages in varying market environments. Just like public equities, it’s very difficult—if not impossible—to time the private equity markets. While they can’t guarantee a positive return or prevent losses, diversification and maintaining a long-term perspective are critical for investment success in private equity.
The drivers of success
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Ultimately, potentially improving long-term investment outcomes is what private equity exposure is all about. For investors with the appropriate risk tolerance, minimal liquidity needs, and who can access top-performing managers, private equity can help add meaningful value to a portfolio over the long term. But all three of those factors are highly important.
Private equity is, well, equity. So all of the risk factors that drive public equity performance are also present with private equity. Investors with a short-term time horizon or low tolerance for equity risk are likely not good candidates for private equity exposure.
Illiquidity is another critical, perhaps even defining factor for private equity. Most private equity funds are structured such that capital calls and distributions vary over time during the course of a fund’s term, often 10 or more years. Most private equity funds contractually require investors to stay in the fund for the long term. The ability to avoid early redemptions is critical for success in private equity.
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But none of that matters without access to the best private equity managers. The costs of private equity are high, which raises the return threshold required for managers to outperform the public equity market. Private equity is only worth pursuing if you have access to the best general partners. The costs and risks of private equity are often too high for average managers to overcome.
For investors who can check all those boxes—sufficiently high tolerance for active equity risk, ability to withstand extended periods of illiquidity, and access to top managers—private equity can add meaningful long-term value.
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