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| Private Equity |
Wisdom & Fair Warning
Laurence Neville
04/01/2004
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“The greatest challenge is dealing with huge lags,” Sasveld explains.
“That challenge leads us to under-allocate, as we know that private equity, as a
riskier investment, is expected to grow faster than the rest of your portfolio.
Of course, it is also not possible to change our exposure.”
The illiquidity
of private equity can be viewed as an opportunity cost—the inability to do
something else with our capital if a better prospect (or a dire emergency) comes
along. This can force us into situations where, pressed for capital to pursue an
interesting entrepreneurial or investment opportunity, we may have to sell our
most liquid assets—say, our stocks or bonds. This can throw our portfolio
allocation out of alignment, increasing our allocation to private equity
relative to other asset classes, notes Patricia Stewart, managing director of JP
Morgan Private Bank in New York.
In these cases, we may suddenly find
ourselves with a portfolio overwhelmingly comprised of assets we cannot easily
sell. While this may seem like a small price to pay, especially if our private
equity investments are doing well, we should bear in mind that situations like
this have precipitated the downfall of many a professional asset manager.
Indeed, a liquidity crisis of this nature caused the demise of hedge fund
Long-Term Capital Management, which boasted Nobel Prize-winning economists among
its partners (though its illiquid assets were not private equity). The
secondary market’s recent burgeoning is due in large part to investors being
trapped by this type of liquidity crunch: Why else would we sell our interests
at such deep discounts? (See “In Calamity’s Wake,” a companion article.) Keeping a healthy
balance of liquid and illiquid investments is crucial.
Private equity’s long
pay-in period also constitutes a challenge for investors. “You need to be
careful what you do with the cash you have committed to a private equity
investment in the years before it is needed,” notes Stewart. If we tie up our capital in another illiquid asset, or put it
in an asset that falls in value, we may not have the money on hand to meet the
private equity firm’s capital calls, when they come. “There are heavy penalties
for not meeting a capital call,” she says, “if you are already committed.” This
is yet another reason for the secondary market’s growth: Those who cannot meet
their capital calls need to get liquidity, either by selling the fund that
threatens to make a capital call, or by selling other funds to raise the money
to meet a capital call. Either solution can throw the investor’s portfolio
allocation out of alignment. Suddenly boosting or dramatically slashing the
amount of private equity in our portfolios wrecks the finely tuned balance (in
terms of diversification, volatility and liquidity) that we work so hard to
establish when devising our asset allocation strategies.
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