Private Investments Risk Part 5: "Allocate, Choose Well, Diversify"
Team up to achieve your best results. I always advise clients that as a team we can achieve more together. The client’s role is to be a disciplined, consistent, annual allocator, especially when markets are down and the world looks scary (opportunity to buy low). The best clients don’t deviate and back away from their commitment budgets. And their expert’s role is to help uncover the best strategies with potential to achieve one’s goals while taking the lowest possible risk. Together, this kind of teamwork tends to produce better results than haphazardly committing to random funds.
As early as 2012, in executing my role as a team player, I attended an exploratory manager meeting with a well-known mega fund to understand how they create value. The senior partner sitting across the table from me explained that the main way their teams created value in their mega funds was via their purchasing savings efforts at their portfolio companies (think buying pens and pencils cheaper). I thought he was joking and I almost burst out laughing. But he was serious and I realized I had to keep my composure. This episode was one of several that alerted me something was terribly wrong with the large buyout space. These mega buyout managers were running out of ways to create value in their portfolio companies outside of using financial engineering, so they were getting very creative with their answers to my questions.
Since 2012, mega funds kept paying up for companies they acquired (the data doesn’t lie) most likely via a competitive bidding process. Yet in 2019, another record was set for fundraising. And again large institutional investors allocated most of their billions to these well-marketed mega funds.
As discussed in earlier articles, when you scratch beneath the surface a bit, you will realize that this is private investing at its worst. Risk is just casually explained away and not deeply considered. Alignment of interest is ignored. Recognized fund house brand names are chosen as they offer a (false) sense of security. Yet of the more than 8,000 fund managers in our universe, there are still dozens and even maybe a hundred who never lost focus on meaningful value creation and deserve our investment consideration. Shifting their focus to raising larger funds at all costs did not tempt them.
Once your expert and you find these managers and check their strategies to your satisfaction, you need to decide how to properly allocate to the space. Depending on your tolerance for a period of illiquidity and ability to set aside a portion of your portfolio for up to a decade, you should consider allocating 10-40% of your portfolio/net worth to what can be a very rewarding asset class (if approached properly). This allocation range is in line with many endowments, respected family offices with experienced professionals dedicated to this effort, and other thoughtful institutional investors. You should budget your commitments over a period of years, understanding that each commitment will take 2-5 years to fully deploy before distributions begin and your allocation starts to diminish again. At that point, an investor needs to remember to keep committing to the asset class to maintain their allocation % target.
And so to achieve your allocation % target, front-end loading your commitment budget makes sense (as much as 40% of your target allocation should be committed in year 1) versus just using straight-line commitments (20% per year) over the initial 5 years. By front-end loading your commitments, you are able to reach your allocation % target within 4-5 years versus never with a pure straight-line approach.
And of course, do not forget to properly diversify without over-diversifying each year’s commitments. Maintain strict discipline in committing to the asset class each year. This is especially important when markets become shaky or enter recessions. Often the best vintage years are those that experience recessions when managers have better pricing power in making their investments. In any one vintage year, a disciplined investor should commit to between 3 and 5 complementary fund strategies.
There is a better way to approach this asset class. As an aspiring or existing asset class investor, partner with an experienced expert to help you ask the right questions and make a better decision. And importantly, maintain your investment discipline via your allocation and diversification strategy. Following this advice will help you achieve consistently above average results in this appealing, yet potentially confusing asset class. Team up with a capable expert and make it work.