Asset allocation has arguably the single most impact on a portfolio’s risk and return. Portfolio weightings must be continuously monitored to ensure they remain within approved ranges and are rebalanced as required. This exercise is relatively straightforward if the portfolio consists entirely of liquid investments because weightings can easily be adjusted by allocating cash additions, or alternatively, through select purchases and sales.
However, asset allocation becomes much more complex when illiquid investments such as private equity and real estate are involved. Achieving a target level of exposure in these categories is difficult for several reasons. First, the speed at which managers call capital varies considerably. Real estate managers tend to invest capital during the first three years of a partnership’s life, while private equity managers take as long as five to seven years to completely invest their fund. But the actual pace of capital calls varies significantly over time, making it difficult to forecast the amount of a commitment that will actually be invested.
The time required to realize returns also varies. Typically, real estate funds harvest their investments in four to eight years and private equity managers return the majority of their capital in five to 10 years (these funds typically have a 10-year life). But these figures represent only averages; actual distributions can occur in less than a year or up to a dozen years.
Private equity and real estate returns vary considerably, making it difficult to forecast the behavior of a given fund. Additionally, as privately held investments, their carrying value may not reflect the return that will be realized.
The amount that should be committed to private investments in order to reach a target level is a function of a number of variables, each of which is subject to considerable uncertainty. Moreover, actual exposure to illiquid asset classes can drift significantly above or below targets as a result of extreme fluctuations in the capital markets. And given the illiquid nature of private equity and real estate, it is difficult and potentially very costly to make adjustments over short time frames.
Given all of these complexities, it would be easy to simply throw up your hands and limit the portfolio to more traditional asset categories. I’m not specifically trying to make the case for private equity and real estate, but both categories have brought investors benefits. Private equity and venture capital have generated returns that significantly exceed those of the S&P 500 over the last 20 years. Real Estate returns are comparable to the S&P index, but with just over one half of the volatility.
Combining real estate and private equity in a portfolio in the correct proportion should both enhance returns and dampen volatility versus more traditional asset allocations. Moreover, the dispersion between the returns of real estate and private equity managers is significant, which means that good manager selection should generate returns substantially in excess of the broad indices.
For all of these reasons, we believe the benefits of private investments far outweigh the difficulties for many investors.
So how much should you commit to illiquid investments and how do you get there? For those clients with sufficient assets, longer time horizons and the ability to tolerate illiquidity, we typically recommend a 5 percent to 10 percent allocation to private real estate and 10% to 15% exposure to private equity, which includes both leverage buyouts and venture capital.
Let’s assume target exposure of 5% in real estate and 10% in private equity. How much should you commit to each category in order to achieve and maintain the targets? First, I believe that it is difficult if not impossible to successfully make market-timing decisions in these asset categories, so we recommend regular commitments and consistent exposure. Second, I strongly believe in diversification, so our vehicle of choice in both categories is a fund of funds that has underlying exposure to 10-20 managers that are carefully selected for both their investment skill and unique strategies that complement the other managers included in the fund.