A private investment, also commonly referred to as an alternative investment, is a financial asset outside public market assets such as stocks, bonds, and cash. Qualified investors often access private investments through an investment fund. Examples of private investment fund sectors include private credit, real estate, natural resources, private equity, infrastructure, and hedge funds.
Although relatively small compared to the overall capitalization of the public market, private investment assets under management grew from $4.1 trillion in 2010 to $10.8 trillion in 2019, and is expected to grow to $17.2 trillion by 2025. Institutions have also greatly increased their portfolios’ allocation to private investments from 27.7% in 2003 to 54% in 2020 on a dollar-weighted average basis. While high-net-worth investors increased their allocation to private investments from 22% in 2017 to 26% in 2020, according to KKR surveys.
With popularity rising among qualified investors, what role do private investments play in investor portfolios?
How can private investments improve an investment portfolio?
Investing in private investments can be an attractive option for qualified investors to increase diversification, reduce portfolio volatility, produce high risk-adjusted returns, and high absolute returns. However, one of the main reasons institutional investors seem to invest in private investments is for the associated diversification benefits.
Modern Portfolio Theory suggests an investor can improve the overall risk-return profile of an investment portfolio by making investments in individual assets and/or specific sectors that have a low correlation to each other. Assets with low correlations have returns that move differently in relation to each other.
Following this line of reasoning, private investments that specifically have a low correlation to the public market, offer an investor the opportunity to further diversify a portfolio, which can be perceived as reducing overall risk exposure across individual investments and specific sectors (idiosyncratic risk) and portfolio volatility, while maintaining overall performance expectations.
Private investments can also offer the possibility of enhanced returns compared to the public market due to minimal investment constraints imposed on fund managers and a wider investment universe available to investors.
For example, hedge funds invest primarily in public market assets but can utilize less common, more sophisticated strategies like short-selling, derivatives, and leverage. Additionally, venture equity gives an investor the ability to make equity investments at the earliest stages of a private company, which would otherwise be unavailable to investors that invest only in the public market.
Naturally, these potential benefits are counterbalanced by the increased risk generally associated with private investment funds as described below.
What are the risk characteristics of private investments?
Private investments come with different risks characteristics than the public market. Private investments are typically less regulated and less transparent, illiquid, and require funding commitments that are called over time.
Compared to the public market, private investments are less regulated.
For example, private investment funds are not required to publicly report their investment positions or returns. This can result in very little information being publicly available to potential investors, making it critical that investors undertake an extensive due diligence process.
The lack of regulation also allows investment managers to employ riskier strategies, utilize more complex legal structures, and keep returns and investment strategies private. The lack of regulation and transparency has resulted in private investments being limited to higher-net-worth investors such as institutions, “qualified purchasers,” and “accredited investors.”
Illiquidity is another risk to investors both at the fund level and limited partner level. The term of a private investment fund can commonly range from 3-10 years, depending on the strategy, with hedge funds being the exception and typically offering full or partial liquidity after one year at monthly or quarterly intervals (for example). The markets for private investment assets are therefore often small or nonexistent during the term of the investment fund, making it difficult for a fund manager to liquidate in times of economic stress.
As a result, a limited partner’s capital is generally made illiquid by the private investment. Investors should actively manage their overall liquidity because issues could arise if the investor has a liquidity need and all their capital is tied-up in illiquid private investments.
The illiquid nature of private investments also creates rebalancing risk. If an investor’s portfolio becomes too concentrated in a specific sector or strategy, it is generally not possible to pare back a position in an illiquid private investment.
Generally, capital committed to a private investment fund is not called all at once. A fund manager will request capital as investment opportunities present themselves, which can often be sporadic and lead to lost opportunity cost as capital waits to be called. Therefore, it is important to actively manage capital inflow and outflows, so enough capital is available when a fund manager requests it.
Funding risks can also arise in market downturns when liquidity dries up and portfolio investments may need more capital in excess of an investor’s original capital commitment.
These risk characteristics are a major driver behind private investments being limited to institutions, qualified purchasers, and accredited investors. However, it is important to keep in mind that some of these risk characteristics can be partially mitigated.
How can these risks be mitigated?
A risk can also present a concurrent advantage.
For example, the lack of publicly available information and small asset markets tend to result in greater pricing inefficiencies than those available in the public market. This creates an opportunity for active management to exploit these market inefficiencies. Therefore, it is important to determine an investment manager’s experience and ability to successfully implement a given investment strategy.
Illiquidity may be mitigated by investing in private investment strategies designed to make regular distributions, often quarterly, over the term of the fund’s life.
Additionally, some strategies utilize an evergreen fund structure that generally allows for partial or complete withdrawals of capital after 1-3 years. The disadvantage of an evergreen fund is that commitments are fully funded upfront, whether or not the investment manager has investment opportunities to invest in at that time.
What are the factors in determining suitability?
When using private funds to pursue an improved risk-return profile for a qualified investor’s portfolio, we believe the biggest factors to consider are the investor’s risk tolerance, liquidity needs, time horizon, and investment objectives. If suitable, extensive due diligence should be conducted to target the best managers with whom to invest, and cashflows should be meticulously monitored to help ensure the investor maintains sufficient liquidity.
If you would like to learn more about Private Investment opportunities or how a wealth manager can help with Private Investments please feel free to contact us.
Tony Miller is an Investment Manager, Private Investments with Schultz Financial Group Inc.
Schultz Financial Group Inc. (SFG) is a wealth management firm located in Reno, NV. Our approach to wealth management is different from many other wealth managers, financial advisors, and financial planners. Our team of fee-only fiduciaries strives to help our clients build their wealth across four capitals: Financial Matters, Physical Well-being, Psychological Space, and Intellectual Engagement. We provide family office and wealth management services to clients located in Nevada, California, and other states. If you’d like more information, please check out our website or reach out to us via our contact page.
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