The rising popularity of private market investing means some of its sectors are overlapping with the public markets. That means advisors must be cognizant of how they invest in specific sectors, according to the latest report issued by J.P. Morgan Asset Management’s Strategic Investment Advisory Group.
Private and public equities have very different data sets when it comes to measuring performance, said Jared Gross, head of institutional portfolio strategy at J.P. Morgan Asset Management. The challenge for advisors will be drawing a clear distinction in their portfolios and firms about how they seek opportunities in both categories.
When advisors invest in public equity funds, they expect high volatility and high-level liquidity. On the private side, they anticipate a very high level of manager dispersion and a very high level of illiquidity.
“When you talk about levels of liquidity,” said Gross in an interview, “that is one of the key areas in which traditional asset allocation models do not do a very good job of estimating liquidity risk and imposing liquidity as a risk factor in the asset allocation process.”
Leveraged buyouts, or LBOs, where debt is used to buy a company in lieu of cash, is part of the private space that has seen significant overlap with the public markets, Gross said.
But there are two areas of private investing with much less overlap.
The first is venture funds, early stage companies whose drivers for value are growth in revenue, Gross explained. Given that it is a highly uncertain business, there is a lot of risk.
“The nature of venture capital is to spread your risk across multiple opportunities, recognizing that some meaningful part of them will come to naught or not deliver high returns, but some subset will deliver extremely high returns,” he said.
Many of those companies remain private longer and accrue more valuation and capitalization. They are not available in the public space.
The other area with less overlap is small and mid-cap traditional private equities. These include traditional businesses that started small, according to Gross. In many cases their founder has grown the business and may have even expanded it throughout a region, but does not have the knowledge, experience or desire to grow it any further.
A private equity firm can add tremendous value to such companies by offering resources to help them expand, Gross explained. An advisor will not find those types of opportunities in the public space.
However, advisors should not be focusing their portfolios solely on public or private equities, as each have their benefits and can generate high returns, the report pointed out.
“You probably want to think as creatively as possible about avoiding overlap in your portfolios so that your [private investments] are doing what only privates can do and your public markets are doing things the public markets are able to do,” Gross said.
Determining the allocation between public and private equity depends on the risk tolerance and circumstances of the individual investor, he added.
“It has to come from the fundamentals,” Gross explained. “Investors who have the flexibility to absorb illiquidity can own larger private allocations without much trouble, while investors who have fixed obligations ... and uncertain obligations ... those are investors who have to be very, very careful about the amount of illiquidity they take on.”
The report advocated for inclusion of both private and public funds within a portfolio because, as it explained, the returns of the two are no longer as far apart as they once were.
“We are not suggesting that public has fully caught up to private or that there’s no return premium whatsoever,” Gross said. “But it’s probably not as big as traditional modeling would suggest, and if that’s the case then asset allocation models that simply assume that return premium may be tilting portfolios more heavily than they should in one direction or another.”
The firm does not foresee public investing performance surpassing that of private investing given the benefits private investing provides, such as control and direct access to a company. In the end, private investing will also always provide greater returns, according to Gross.
“Private investing has a number of mechanisms to generate returns that public equity does not have,” he said. “[However], an active public portfolio remains an extremely attractive way to allocate capital over the long term.”