Private Investments Risk Part 3: "Should We Allocate to EM Private Funds?"
Don’t get me wrong! Having a proper allocation to emerging market equities and fixed income is probably a very good decision, but illiquid, private investments are an entirely different story in terms of emerging market risk and reward considerations.
Really smart people build portfolios with emerging market allocations to private investments that mimic emerging market allocations in their public positions. But these two allocations should be viewed entirely differently given the illiquid nature of private investments. Risk assessment should not be disregarded as much as it is in emerging market investment decisions. One must be paid for higher risk tolerances with outsized relative returns.
The trouble is that in the private space, outsized emerging market returns have been few and far between, but their associated risk profiles are clearly greater in almost every direction one looks. Just think about Abraaj’s fraud leading to their collapse, or the Chinese government making high profile private investment managers disappear only to be replaced by the government’s own proxies, or currency shocks and fluctuations in Latin America driven by uncertain political climates.
If you knew in advance that these events would take place would you still invest in these opportunities? Of course not! And since we do not have the benefit of hindsight when looking to allocate to future opportunities, we can only imagine what might go wrong and then assess our comfort level with that list of potential factors.
Developed market private funds, in general, just don’t have the same elevated risk profiles and deliver relatively similar returns. So why do really smart families and institutions continue to allocate to private emerging market investments? Clearly, they view the risk profile to be tolerable and view the relatively muted returns to be acceptable. It seems as if it is just more important to check the box and allocate some portion of their portfolio allocation to this area. This behavior is a part of a portfolio allocation theory that in practice just doesn’t assign the needed weight to most of the associated risks.
We have a different view. We think there is a better way to allocate to private investments. Allocations should be based first and foremost on mitigating risk and choosing high quality investments with the lowest relative risk profiles. If a stable, thematically relevant, risk mitigated private investment fund based in the US delivers a decent return potential, then one should not allocate to riskier emerging market opportunities that do not provide truly outsized returns. A safer investment environment with a sound strategy should outweigh the check the box allocation exercise.