TIAA (Teachers Insurance and Annuity Associations of America Endowment & Philanthropic Services) has published a paper offering insights into the optimal way of building an allocation to Private Equity (PE).
“Private equity is an important part of institutional portfolios. It provides attractive opportunities for long-term investors to harvest the illiquidity premium over time and extract the value created by hands-on private equity managers.”
Private equity is by its nature is illiquid. This in turn makes rebalancing a challenge. That is why a PE allocation that is too large endangers the entire portfolio, especially in times of crisis when secondary markets seize up.
According to recent analysis by Prequin, the popularity and growth of PE, and other alternative investments, is expected to continue.
Furthermore, recent Cambridge Associates analysis on those Endowments and Foundations with the better long-term performance records had “one thing in common: a minimum allocation of 15% to private investments.”
We all know, a robust portfolio is broadly diversified across different risks and returns. Increasingly institutional investors are accepting that portfolio diversification does not come from investing in more and more asset classes. This has diminishing diversification benefits.
True portfolio diversification is achieved by investing in different risk factors, for which illiquidity is one factor.
In my mind, direct private investments, such as Private Equity, Direct Property, and Unlisted Infrastructure have a place in a genuinely diversified and robust Portfolio.
From this perspective, the TIAA paper is very useful as it considers how to build and maintain an allocation to PE within a well-diversified portfolio. They assume building out the PE allocation over time to an equilibrium allocation.
The Paper provides valuable insights into the asset allocation process of what is a complicated asset to model given cash commitments (capital calls) are made overtime and there is uncertainty as to when invested capital will be returned (distributions). TIAA model for both of these variables, in a relatively conservative manner.
The TIAA Paper notes that investors have no control over the rate and timing of capital calls and distributions. Therefore, the paper focuses on two key variables Investors can control for: an annual commitment rate and the risk profile of the assets waiting to be invested in private equity assets i.e. where to invest the cash committed to PE but not yet called.
TIAA propose a robust process to determine an appropriate allocation to PE to ensure the allocation can be maintained and the benefits of PE are captured over time.
“Obtaining the benefits of an allocation to private equity, while also avoiding its inherent illiquidity pitfalls, can only occur through an effective, risk-based strategy for executing the build-out to the long-term equilibrium state.”
The goal of the paper is to develop a framework and a sound approach.
TIAA’s modelling suggests that a target allocation to private equity strategies in the range of 30% to 40% presents minimal liability and liquidity risks.
TIAA also suggest, that for long term investors, such as Endowments, capital awaiting investment in private equity should be invested in risk assets with higher expected returns, such as public equities (sharemarkets).
This level of allocation is probably high for most, and particularly KiwiSaver Funds.
Nevertheless, KiwiSaver Funds are underweight Private investments and Alternatives, particularly relative to the Superannuation industry in Australia.
Given the overall lack of allocation to private investments, including PE, Direct Property, and Unlisted Infrastructure, many KiwiSaver providers are most likely over estimating their liquidity needs to the detriment of investment performance over the longer term.
For those wanting a discussion on fees and alternatives, please see my previous post Investment Fees and Investing like an Endowment – Part 2.
With regards to the TIAA paper, they develop a simple three asset portfolio of Fixed Income, Public equities, and Private equities. TIAA use sophisticated modelling techniques looking at a number of variables, including:
- the annual commitment rate; and
- Risk profile of the assets waiting to be invested in private equity.
The annual commitment is defined as the new commitment to private equity every year as a percentage of last year’s total portfolio value.
“An annual commitment rate results in a long-term equilibrium percentage of the portfolio in private equity assets, as well as the portfolio’s corresponding unfunded commitment level. The unfunded commitment level is important from a risk perspective as it represents a nominal liability to fund future capital calls, regardless of the prevailing market environment at the time of capital calls.”
TIAA note that at low rates of annual commitment the equilibrium rate of PE is about twice the unfunded ratio. Therefore, a 6% annual commitment rate will result in a base case unfunded ratio of around 15%, and a PE allocation of around 30% at equilibrium.
For those wanting a brief overview of the methodology, All About Alpha provides a great summary.
There is no doubt that Alternatives are, and will continue to be, a large allocation within more sophisticated investment portfolios globally.
As Prequin note in this report, investor’s motivation for investing in alternatives are quite distinctive:
- Private equity and venture capital = high absolute and risk-adjusted returns
- Infrastructure and real estate = an inflation hedge and reliable income stream
- Private debt = high risk-adjusted returns and an income stream
- Hedge Funds = diversification and low correlation with other asset classes
- Natural Resources = diversification and low correlation with other asset classes
A well diversified and robust portfolio will be able to meet these motivations.
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