Many investors have moved to private equity in recent years in order to enrich the yield potential of their portfolios. But the influx of funds, in addition to trepidations with regard to the strength of the global economy, has some investors questioning the validity of private equity in the future.
Northern Trust utilizes private equity as an essential building block for qualified investors’ portfolios. According to Northern Trust Management CIO Katie Nixon, this is because private equity is ideally suited to assist clients in reaching long-standing goals. Northern Trust executes intensive research at the asset-class level to truly comprehend the sources of risk that drive returns, only accepting the risk that is advantageous for the client. After performing such research, it is the opinion of the firm that private equity offers a myriad of advantages. The first of which is that the class asset promises superior revenue potential. Examination validates that the long-term performance of an average private equity fund will outpace public equity. This is credited to what is referred to as “the illiquidity premium – the extra compensation demanded by investors to invest in an illiquid asset,” says Nixon. Secondly, the asset class has probable variation remunerations.
“I say probably because the diversification benefits of private equity are driven by manager skill or ‘alpha.’ Alpha enhances broader portfolio diversification because it is a unique source of return that is uncorrelated to other sources of return. But access to skillful managers is key,” Nixon mentions. Lastly, private equity helps to eliminate investors’ behavioral biases; due to the lack of liquidity, selling during market anxiety is not possible and guarantees investors will continue with the decided long-term plan.
The correct percentage of a portfolio assigned to private equity is unique to each client. Northern Trust is extremely adept at assessing and identifying each client’s individual needs and advising on the correct allocation. Northern Trust begins this assessment by categorizing asset classes into two unrelated groups of “super” asset classes – which the firm refers to as “Risk Control and Risk Asset portfolios.”
“We determine the optimal mix of asset classes underneath these two categories, including private equity within the Risk Asset portfolio,” explains Nixon. “From there, we determine the actual size of individual investors’ allocations by finding the optimal mix of Risk Asset and Risk Control portfolios that align with their unique objectives. For clients in our Goals-Driven framework, this mix reflects the time horizon of their goals and the degree of confidence they desire for attaining each goal. In practice, this results in a wide range of allocations to private equity and other alternative investments – anywhere from roughly five to 40 percent that is largely a function of each client’s time horizon and liquidity preference.” It is imperative to mention that private equity requires a continuing commitment.
Once the allocation has been determined, it can be challenging to attain and sustain due to the fact that you must recurrently make new investments to counterbalance allocations from maturing funds. Northern Trust believes it is good measure to pledge half of your intended allocations every second year.
“Ultimately, the success of private equity investments hinge on the skill of the manager and their ability to deliver sustainable, long-term returns above and beyond the broader illiquidity premium offered by the asset class. So that is where we focus,” says Nixon.
In 2018 Northern Trust launched its ArcLine Alternatives platform, which seeks out distinctive and distinguishing plans and managers with steadfast credentials of producing alpha. Fascinatingly, many private equity managers that achieve top-quartile results tend to demonstrate obstinate top performance in the long run, as opposed to public equity managers. “Private equity strategies focused on smaller- and medium-sized private businesses, where there are less money-chasing opportunities, offer compelling long-term value,” says Nixon. “Our affiliate, 50 South Capital, focuses on this space, with a similar emphasis on manager skill.”
Lately, there has been quite a bit of news surrounding concerns on high private equity valuations. Nixon maintains that there is no doubt that valuations are high. “Fundraising has been prolific with non-traditional investors, such as hedge funds and even mutual funds, increasingly participating in the private equity market,” she says. “Plus, companies are staying private longer in recent years, receiving successive rounds of financing at valuations closer and closer to public markets, further contributing to elevated valuations.” As such, those investing must be shrewd and lower their return expectancies, but it does not mean that investors should avoid the asset class. Even if the potential return is lower, discerning private equity investments will continue to provide superior return potential, more so than public equity, as well as portfolio diversification benefits.
So what do you need to know? “Private equity is a fundamental component of globally diversified risk asset portfolios – not a fringe asset class. By offering alpha – it acts as both a return enhancer and portfolio diversifier and is therefore instrumental in helping qualified investors achieve their goals. Of course, investors need to be aware and comfortable with its risks and illiquidity. But in most instances, the benefits of the asset class outweigh these hurdles, says Nixon. Private equity demands devotion. Investors must commit to having their money tied up in an inaccessible investment and consistently make new investments in order to sustain the desired allocation. It is important to not only understand but also embrace the required dedication from the start. Lastly, choosing the correct strategies is of the utmost importance. Not all private equity managers dependably generate alpha; sub-standard performance tends to occur. When gauging performance, investors need the knowledge and tools to discern manager skills from more readily available sources of return. Northern Trust’s method focuses on exactly that.