The difficult markets of 2022 have reminded investors of the importance of diversification, particularly in portfolios that support spending. Many US tax-exempt organizations have also learned that seeking investments outside of volatile public markets can strengthen portfolios for the long term.
Now, a newly released study covering private and community foundations in the US underscores the point. Findings from the Council on Foundations and Commonfund show alternative investments—and private equity in particular—gathering momentum. According to the report, foundations both large and small (community and private) are allocating anywhere from a quarter to half of their portfolios to alternatives.1
Drilling down, marketable alternatives represented the largest line item. But combining private assets together (equity, debt, and real estate) captured most of the alternatives’ exposure. For the larger pools (over $500mm), venture capital and private equity ranked #1 and #2 when it came to private investments. Under $500mm, private equity took the top spot.
What’s more, for the third straight year, both private and community foundations saw the largest potential increases coming in private equity—typically at the expense of traditional stock and bond allocations (Display). Yet whether this comes to fruition remains to be seen. While the 2021 survey showed a meaningful pickup, this year’s market gyrations have clearly influenced ongoing allocation targets. In fact, some larger institutions are now overallocated given public market declines.
A Different Way
How does private equity work? Investors take a stake in a company, just like public stocks. But unlike securities in the public market, private investments do not trade on an exchange, and the money invested is generally tied up for many years. The differences don’t end there. Investing in public stocks means you own a (typically very small) share of a company, and for the most part, there is very little you can do to influence the company’s operations. Private equity, on the other hand, represents direct ownership, usually by taking a controlling position or a significant, active minority ownership interest.
Private equity owners seek to create value over time by increasing cash flow, generally from internal growth initiatives, exploring potential mergers or acquisitions, and/or through cost rationalization. They often add value to businesses by improving corporate governance, upgrading management, and assisting with strategic and operational initiatives. Examples of the latter include rolling up businesses in the same industry, fostering organic expansion, promoting cost rationalization, and implementing innovative technologies.
Progress and results are evaluated over the span of multiple years, affording business owners time to make improvements without being forced to meet the quarterly earnings goals that the public markets often focus on.
But that doesn’t mean the only way to be a successful private investor is to bring the company public. The private equity market offers owners multiple options for enjoying a return on investment: an initial public offering, a sale to a strategic or financial buyer, or simply maintaining a stake and benefiting from the growth and cash return of the company.
Advantages: Performance and Diversification
Perhaps due to this longer-term perspective, private equity has historically outperformed most public equity markets over the long term. Consider that investors in the asset class earned 23.5% versus 15.3% for global equities for the five-year period ending December 31, 2021.2 Diversification is another benefit: the pattern of returns tends to differ from that of public equities, actively offsetting their performance. Further, while the number of publicly traded stocks is shrinking, a trend that started in the last few years, the number of private companies is growing, offering a greater pool of candidates from which to choose.
In Search of a Smoother Ride
For some organizations, the inability to exit an investment at will may not be feasible or meet their risk tolerance. For others, illiquidity can be borne, but only for a certain portion of their assets.
How can you decide if private equity is right for your organization, and how much makes sense? To answer these questions, your investment committee may first need to answer another: Do daily gyrations of the stock market worry you? Investing in public equity markets requires a tolerance for volatility. Stock prices, and markets overall, tend to respond precipitously to news, whether it’s on individual company performance or macroeconomic influences.
During some days, quarters, or even years, macroeconomic forces that have nothing to do with a company’s fundamental strengths may be the only cause of market movements. Geopolitical headlines, changing interest rate regimes, rising or falling inflation readings, and currency movements can mask the blemishes or the brilliance of any public company. In contrast, private investments do not react immediately to such short-term market turbulence.
How Much Should You Allocate?
Private equity is attractive on many fronts: It offers a non-correlated return stream alongside public stocks, and potentially robust long-term performance with minimal, if any, daily price fluctuations. But since these investments are less liquid, generally requiring an investment horizon of 10 years, most organizations can only hold a portion of their assets in private equity. That’s why it typically complements a public equity allocation.
Constructing an appropriate asset allocation depends upon each organization’s unique investment criteria—time horizon, capacity for illiquid investments given spending needs, preexisting liquidity bias, and risk tolerance. Plus, an asset allocation that includes private equity, among other alternative investments, must account for its unique risks, with heightened consideration for:
- Maintaining sufficient liquidity, even in the most difficult markets, to support spending without any shortfall.
- Keeping target allocations around the weight of illiquid positions flexible; drift from the initial target allocation should be expected. Rebalancing a portfolio that includes illiquid investments is difficult, if not impossible.
Notably, private equity investments are designed for the long haul. They often require a deliberate “vintage year” strategy to slowly build up—and eventually maintain—a target allocation to the space. Ultimately, while certain vintage years may underperform, institutions that have remained committed to private markets have been rewarded with higher returns and lower volatility relative to public equities.
Also, remember that alternative investments are not a monolith, and their considerable idiosyncratic risk tends to result in a much higher dispersion in manager returns. Research shows that a successful alternatives program requires access to top-quartile managers to improve risk-adjusted returns compared to more liquid counterparts.
Investing in private equity can provide substantial benefits to foundations. But like other alternatives, it is not without risks. Consulting with investment, tax, and audit advisors is essential.
- Greg Young, CFA
- Senior Investment Strategist—Foundation & Institutional Advisory
1 The Council on Foundations and Commonfund recently released their 2021 Study of Investment of Endowments for Private and Community Foundations, which surveyed 231 private and community foundations representing approximately $120B in assets.
2 Past performance does not guarantee future results. Private equity is represented by the Cambridge Associates LLC US Private Equity Index. The index is a horizon calculation based on data compiled from 1,387 US private equity funds, including fully liquidated partnerships, formed between 1986 and 2021. Data is a pooled horizon return, net of fees, expenses, and carried interest. Global equities are represented by a constructed Index: MSCI World/MSCI All Country World Index: Data from 1/1/1986 to 12/31/1987 represented by MSCI index gross total return. Data from 1/1/1988 to present represented by MSCI ACWI gross total return. Sources: Cambridge Associates LLC, Frank Russell Company, MSCI Inc. and Thomson Reuters Datastream.