Asset allocation: what is the right approach?

What should be the share of private equity in the portfolio of European institutional investors? The answer, according to research from the European Venture Capital Association, CDC Ixis Capital Markets and the Center for Entrepreneurial and Financial Studies Technische Universität München, is between 5% and 10% when the portfolio consists of private equity, quoted equity and bonds.

A major issue faced in the research was determining the right performance metrics in order to compare the returns of private equity with more liquid asset classes. Two sets of data were used to conduct the analysis. The first one consisted of periodical aggregate returns built on the sum of all the funds for a specific period of time (i.e. the sum of the cash flows and net asset values between the starting and the ending dates of the chosen period). The second set of data consists of cash flow patterns (amount and exact timing) based on data of individual funds.

In a panel discussion at the annual EVCA International Investors’ Conference industry experts discussed how LPs build their private equity portfolios today. How many funds there should be in an ideal portfolio? For the best diversification, around 30-40 active funds across four or five vintage years, according to Christian Mayert of Allianz Private Equity Partners GmbH. “If you go beyond that, you don’t add the benefit of diversification but you could add to the risk of sub-par performance.”

It is important to diversify across management style and sector and not just by vintage year. Also, LPs’ attitudes to risk are different. For example, a pension fund has an average liability of 35 years and so liquidity risk is not on the agenda. This, according to the panel needs to be acknowledged and there needs to be an understanding of how the private equity LP base is composed as some investors may have shorter liquidity horizons than others.

Kerrin Rosenberg of global consultancy firm Hewitt Bacon & Woodrow, recommends allocating less than 10% of an institutional investors’ total fund portfolio to private equity. He advises: “Don’t treat private equity like other asset classes. The average private equity fund probably does make money compared to the public markets but it takes that money back in fees and the net returns to investors are no better. Your whole motivation must be the ability to achieve and access an above average return – however, don’t just go with a fund-of-funds because they have the right number of relationships, you need to pick the better funds. It is a question of how much money you can afford to lose – could you bear the loss of having chosen lower quartile funds?” But he adds even if lower quartile funds are posting performance 15-20% below the public markets, a 5% total allocation to private equity would only result in an overall loss of 1% to the entire portfolio.