To determine an ideal exposure to real estate and private equity, it is necessary to build a sophisticated model that forecasts the pace of commitments, fund returns, the timing of capital distributions and the return on the overall portfolio. This includes several important assumptions: private equity return of 11 percent, real estate return of 8 percent, total portfolio return of 7 percent and annual portfolio spending rate of 4 percent. Based on these assumptions, I’d recommend a real estate target of 5 percent, with an annual commitment of 1.1%, and a private equity target of 10%, with an annual commitment of 2.4%
The recommended commitment levels may seem large in comparison to the targets, but it is important to remember that each commitment is drawn over a number of years, and some capital begins to be returned three or four years into the life of a fund. Interestingly, even at these commitment levels, actual exposure does not reach the target levels until year seven in the case of real estate and year 10 for private equity. Thereafter, the exposure remains fairly constant at the target level.
One might ask whether it makes sense to make a larger initial commitment in order to reach the target sooner. Unfortunately, this strategy might necessitate lower commitments in future years in order not to exceed the target. I favor level commitments in order to avoid being on the wrong side of the market cycle. It is also important to remember that these recommendations are based on a number of assumptions that may or may not turn out to be correct, so it is important to periodically repeat this exercise and adjust as required.
In summary, significant commitments to private investments are required to reach target levels deemed sufficient to meaningfully impact the risk and return on the overall portfolio. Second, it is important to realize that the introduction of private investments makes the process of establishing and monitoring asset allocation levels less precise. Moreover, actual weightings can easily fall above or below approved ranges, and rebalancing may not be accomplished easily.
However, we expect that you will be paid handsomely for this added complexity, particularly in a world of low interest rates and the prospect of only moderate returns on most of the traditional asset classes.
Bill Spitz is principal and Director at Diversified Trust in Nashville, Tenn.