Yale's David F. Swensen held the unofficial title of investment genius for many years until his model nose-dived with everyone else's in the 2008 crash. The concept, originally crafted for university endowments and later emulated by countless other institutional investors, espoused shifting money out of traditional stocks and bonds into higher-yielding alternatives such as hedge funds, real assets (commodities and real estate) and private equity.

Swensen's rationale was that private investments offer greater value than public markets. Private assets tend to be less inundated with capital, which makes them more attractive because the inefficiencies are theoretically easier to find than they are in public markets and the prices less frequently bid to extremes. Therefore, the theory goes, diversification into private alternatives simultaneously reduces risk and enhances return. Private assets also pay risk and liquidity premiums less available in public markets.

But even though private markets might be good for some diversification, there are two significant hurdles in this space.

One is that many private assets are illiquid. In bull markets, it's common to hear investment strategists advising clients to sell liquidity, believing it's worth the sacrifice to take the higher return on illiquid investments. That strategy can backfire, though, exactly as it did in 2008, particularly for investors lacking the financial stamina to wait it out. Liquidity is rarely appreciated by investors until they don't have it.

The other hurdle is that private equity investments in particular generally depend on financial leverage and therefore on low interest rates-in other words, on what can be funded through a bank. In the LBO sector, for instance, investors use large amounts of debt to buy companies, hoping to make a few organizational or marketing tweaks, before re-entering the market via an IPO to pay off the debt and make a killing. That's only possible when a lot of cheap debt is available.

Thus, success with private equity investments is often more about the overall economic environment than it is about the particular deal. This is why the "vintage year" is so important in private equity investing.

LBO and mezzanine (essentially, debt restructuring) strategies generally have short time horizons. The only way to make big returns quickly is with leverage.  If cheap financing is not available and/or the economic environment sours, these strategies can suffer greatly. Two other private markets, venture capital and angel investing, involve injecting private capital into new businesses to either start them up or advance them beyond the start-up phase. But neither of these has fully recovered since the tech bubble burst.

The terms and fees charged by private asset managers, meanwhile, tend to be onerous. This means private equity investments must well outpace public equity markets on a gross basis to offset management fees and compensate the investor for taking the significant economic and liquidity risks.

You have big advantages, of course, if you are Yale. Your size and industry connections allow you to get the pick of the high-quality litter-a narrow space-and negotiate lower fees and more attractive terms. Yale also has the capacity (even if the university takes heat about it from media) to withstand a bad year or two of illiquidity. The university will likely go on in perpetuity and is only mildly susceptible to cash-flow problems. If the economy is having a bad couple of years, the university can reduce its endowment's distributions for a while and wait for liquidity to return to the market. Because the portfolio is so large and diverse, the university can meet cash-flow needs, if it has them, by using other parts of its portfolio without doing too much harm.

Real People
But individuals-or even families with $40 million to $50 million in assets-are not like Yale. It makes no sense for wealthy families, for instance, to add private equity to their portfolios when the bulk of their wealth is already in various forms of private equity: real estate and entrepreneurial business. They should be looking instead at something highly liquid to counterbalance their existing holdings, not emulating the Yale model.