12 Dec DIVERSIFYING INTO PRIVATE EQUITY
Portfolio diversification in the current volatile economic and geo-political risk environment is essential for effective risk management. The inclusion of private equity (and other alternative strategies) can assist managers and investors to diversify and improve the quality of their portfolios over time.
Even Regulation 28, under the Pension Funds Act of 1956, now allows for the inclusion of private equity funds to a maximum of 10% of the portfolio. Of this, any single private equity fund may not exceed 2.5% and a fund of private equity funds may not exceed 5%.
Diversification aside, performance is another reason why investment managers and investors are looking closer at including private equity in their portfolios. According to the latest RisCura SAVCA South African Private Equity Performance Report, private equity delivered an annualised internal rate of return of 18.1% over ten years as at June 2016. Private equity outperformed the FTSE/JSE ALSI’s annualised IRR of 12.6% and the FTSE/JSE SWIX’s annualised IRR of 14.0%, and was in line with the 18.0% annualised IRR from the FTSE/JSE FINDI, for the same period.
WHAT MAKES PRIVATE EQUITY AN ATTRACTIVE ALTERNATIVE TO LISTED EQUITY?
- Emotions aside
Because listed equity is highly liquid, valuations are often affected by investors buying or selling when emotions run high. With private equity, assets are not liquid so valuations are driven by fundamental factors.
- Low correlation
Managers are continuously looking for uncorrelated assets to assist in the diversification of portfolios. Because the fundamental valuation of private equity assets follows medium to long term drivers of the assets, correlation between private equity and listed equity tends to be low. This contributes to very effective portfolio diversification.
- Lower volatility
Because private equity assets are not liquid and cannot be disposed of easily, volatility is substantially lower than listed equity.
Remember that volatility is not the only way to measure risk, it tends to be short term centric and does not always capture long term risk. Other risks include that companies can fail, business models can become uncompetitive over time and a company’s cash flow can become inadequate to meet its obligations – volatility does not measure these risks. Diversification in a portfolio can help prevent a default event from becoming a serious risk to investors and understanding the quality of assets can help to reduce cash flow risk.
When one considers the prospect of increased returns and diversification, having some private equity exposure can play a role in investment portfolios. Private equity however will lean naturally towards being more aggressive. This means that investors will need to have a level of sophistication, the ability to invest for a longer period and potentially, the ability to absorb a loss of capital. The lack of liquidity in private equity investments makes this a long term investment option, so it should form part of a long term investment strategy.
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