Maximizing your PE strategy: the importance of diversification

Maximizing your PE strategy: the importance of diversification

At August, we have always been strong believers in private equity and its many advantages over public markets (access to the 'real economy', alignment of interests with shareholders, focus on long-term value creation, optimal financial structure of acquired businesses, ability to attract top talent). This is especially true in today's times of geopolitical and macroeconomic volatility. But in order to fully benefit from the advantages the PE space has to offer, it is important to keep a few investment principles in mind.

Diversification - the only free lunch in investing

Among these three principles, diversification is probably the one that is best known by investors and yet often overlooked.

The importance of diversification in an investment portfolio has been the subject of ample academic research, and its benefits are well known: reduced portfolio volatility and capital loss, smoothened financial returns, exposure to different market and sector trends, etc. As the late Nobel Prize winner Harry Markowitz once said, “diversification is the only free lunch in investing”. Although studies illustrating the benefits of diversification have mostly focused on public markets, their conclusions also apply to the private markets space, especially given the more illiquid (no established primary and secondary market) and less data-driven (valuations are monthly or quarterly instead of daily or intraday) nature of private investments.

In addition, the private markets space is a vast and complex one, with very different strategies coexisting within the same label, from early-stage investments into young and unprofitable companies to project-based investments with infrastructure-like returns. Therefore, as pointed out by insurer Aon, some strategies exhibit their own cyclicality distinct from overall global economic conditions and market cycles. Furthermore, there is a very wide dispersion in terms of risk and return expectations across strategies.

How to diversify in PE

Given the numerous dimensions a PE investment can take, well-constructed private equity portfolios are typically diversified across multiple areas, including vintage year, geography, strategy, manager, and industry.

This obviously creates a challenge for non-institutional investors: whereas in public markets, ETF's are available at the distance of a click and with rock-bottom minimum investment amounts, creating instant diversification, such a solution does not exist - yet - in private markets. PE funds are often closed-end, highly targeted in their investment approach, and only available to investors capable of committing large amounts (often above €1 million).

In our previous blog post, we identified funds of funds (FoF) as the best way to create a well-diversified PE portfolio. A FoF is a pooled investment fund in which capital commitments from many investors are invested across a diversified list of PE funds based on several investment criteria (target geography, sector, size, etc.). A FoF is advantageous for both investors with small private equity allocations (as they can diversify their portfolio without having to invest large amounts) as well as for investors with large private equity investment allocations (as they can gain access to smaller corners of the PE market). Moreover, financial returns can be more attractive than investing in companies or funds directly.

Do you want to find out more about investing in a private equity fund of funds? Read all about it in our website.