Coming to grips with liquidity risk is trickier—and may prove to be a barrier to some of our private equity ambitions. Advisors suggest we consider our liquid assets, liquidity needs and age before jumping in. “Only when a client reaches a threshold of $5 million to $10 million should he consider private equity investment,” says Robert Morgan, senior vice president and director of private equity at Northern Trust Global Advisors in Chicago. Evan Roth, partner at BBR Partners in New York, adds: “Be aware of your time horizon. Private equity is not suitable for the old or the young, who might have short-term liquidity needs.”

Patricia Stewart, managing director of JP Morgan Private Bank in New York, says that while there is a need to acknowledge portfolio concentration risk, one of the rationales of investing in private equity is that we are making a more concentrated bet on small companies. “From a return maximization perspective, there is a need to concentrate on where the best opportunities are,” she says.

Another crucial consideration is how a specific private equity investment will sit alongside our other assets. If this investment diversifies our portfolios, it will reduce our overall risk. If a private equity investment, on the other hand, results in a large concentration of exposure to a particular asset class, sector or investment style, we will have increased our portfolio-wide risk level by decreasing our diversification.

We must also be aware of our existing private equity exposures, which might not be immediately apparent. Roth warns that we may have a high exposure to private equity through ownership of our own companies. Michael Schweitzer, managing director and co-head of private wealth services at UBS Financial Services in New York, agrees: “We deal with a great number of clients who are entrepreneurs. [Clients] will hold significant positions in their companies, and it is important for us to include such assets in our asset allocation work.”

Awash in Illiquidity
Private equity is a very long-term and illiquid asset: It has a long-negotiated investment process, a long hold period, and a long sale process, making exits from a fund difficult for investors. “While a secondary market is developing for private equity fund investments, investors may have to accept a large discount if they want to exit,” says Northern Trust’s Morgan.

“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.

Dead Reckoning
Deciding whether any asset meets our risk-and-return target—or whether it will work alongside our other investments—requires data. Unfortunately, as with other alternative asset classes, such as real estate and hedge funds, the risk, liquidity and return parameters of any specific private equity fund are usually hard to pin down.

The consensus among private bankers and investment advisors is that most of us should look to invest between 5 percent and 15 percent of our portfolios in private equity. Those of us with assets of $50 million to over $100 million can boost the top figure to 30 percent, as we have more liquid assets to call on should an emergency—or an investment or entrepreneurial opportunity—arise, according to Thane Stenner, a wealth advisor and author of True Wealth: An Expert Guide.

Private equity performance information differs from other asset classes in both type and frequency. Unlike other asset classes, returns are expressed in Internal Rate of Return (IRR). Funds typically only report information to investors every three months. “Private equity data relies on either appraisal valuations, which can vary according to fund, or book value,” says David Rosenberg, managing director, head of U.S. investment solutions at the Citigroup Private Bank in New York. Alternatively, some funds hold investors at cost until exit. “If any of these return valuations are put into a return series [used for asset allocation], the outcome is questionable.”

These problematic valuations are used to model return volatility, the most basic measure of an investment’s risk. But these figures are also incomplete: While historical data for the public stock markets goes back to the 1800s, recorded data for the alternative investment market has only existed since the 1980s. That absence of information over more than a handful of economic cycles means we still know little about how private equity behaves in certain economic climates.

“There is a tendency among clients to consider volatility simply as it impacts the balances on their monthly statements,” says JP Morgan’s Stewart. These figures are only snapshots: If a fund reports a similar value in two consecutive quarters, it may draw attention away from what could be wide swings in value. “If investors don’t see that volatility—which they may not as valuation may only be quarterly—then it is not there [in their decision-making],” she says. “We try to help clients understand that private equity can experience substantial volatility, and that they should factor that into their thinking.”

Rosenberg agrees that, in the past, some people have considered private equity less volatile than public equity “because private equity highs and lows have been cut off due to these valuation problems.” Investment advisors know they are, essentially, dead reckoning when it comes to private equity investments, and to compensate, they have simply reduced their clients’ portfolio allocations—tantamount to driving more slowly in the fog. However, for those of us who demand a best-of-breed investment strategy, this approach falls short in two crucial ways. First, it has no scientific basis; it is risk management by fiat and may seriously constrain our private equity returns. Second, without data on a fund’s volatility and its correlative behavior vis-à-vis other assets, we cannot ascertain whether it will diversify our portfolio, or cause unwanted and risk-worsening asset concentrations.

Beyond Markowitz
When Harry Markowitz formulated modern portfolio theory in the 1950s, he realized that a person could find an optimal risk-reward tradeoff in a diversified portfolio if its constituent assets’ prices, volatilities and correlations were known. Unfortunately, this formula did not cover alternative asset classes such as private equity. One of the presumptions of this theory (the descendants of which still inform investment decision-making today) is that markets are open, efficient and accurately priced. “That enables you to capture risk and correlation between asset classes in a portfolio,” says Citigroup’s Rosenberg. “But if that assumption is incorrect, then the risk measurements of the entire portfolio could be wrong.”

Most investment advisors use private equity IRR data collated by Thomson Venture Economics, a data vendor, to assess returns across the industry. They then make an assessment of risk, or volatility, by taking a proxy, such as the volatility of public companies, and multiplying it by factors that account for the ways in which it differs from private equity. For example, the financial advisor might factor in private equity-backed companies’ lack of revenues, unproven technology and management, and uncertain capital structure. The outcome of this heuristic is clearly biased by the analyst’s belief in the prospects of the private equity-backed companies.

Northern Trust’s Morgan explains his firm’s approach: “We use the Russell 2000 plus a small premium and the standard deviation of the Russell 2000 [to calculate volatility]. It is not strictly correct, and there probably is not a correct answer, but it is a suitable base on which to make assumptions,” says Morgan. “Of course, that is only for modeling purposes; you need to more fully understand the asset class to appreciate how it performs and how the investment works.”

The Thomson Venture Economics data also has some intrinsic problems, creating an illusion of low risk because it is not market-to-market. It also has selection bias: “The best managers don’t tend to report their performance,” Rosenberg says. “If they don’t need to raise funds, then many feel there is no need to provide information.”

Private equity risk estimates differ, but not by too much. JP Morgan Private Bank’s current assumption is that the public market has around 15 percent volatility, while the private equity market has 30 percent volatility. Derek Sasveld says that UBS calculates that the risk level of private equity is 1.6 times that of the public market: While the public equity market has 16 percent anticipated total risk (based on standard deviation or volatility), the private equity market risk is 26 percent, including the illiquidity risk.

This data also suffers from survivorship bias. If a fund ceases operation, which usually occurs because of poor performance, it is removed from the index, and its returns are extracted from the data from the day the fund started. “These biases thus remove the best and worst performers from the database in the index, making the volatility appear much lower than it really is,” Rosenberg notes.

There are a number of ways to counter these problems. Sasveld says that to compensate for the lower volatility of reported private equity returns, UBS turns all public equity investments into hypothetical IRR figures, so that they can better show the correlation between public and private equity. “In other words, we treat the S&P 500 as if it were an illiquid private equity fund.”

The benefits of private equity may never be fully quantifiable using the tools developed for other asset classes. But some argue that this presents no significant problems. “What’s nice about private equity is that, to a large extent, it doesn’t fit into any model,” says Morgan. “By that I mean the asset class is different from public equities, with different return patterns, cash flows and valuation methodologies. It’s more inefficient than the public markets, and it’s those inefficiencies of the market that create the return opportunities. Investors need to understand this to profit from it.”

Wheat and Chaff
Citigroup has developed a platform called Whole Net Worth Asset Allocation that attempts to more accurately adjust for the problems of misvaluation and stale pricing in private equity and to better reflect the correlation between public equity and private equity. While its specific workings remain proprietary, its conclusions are illuminating.

“After our adjustments we have found a doubling of the risk in venture capital investments compared to available indices,” says Rosenberg. “The likely outcome is that a client, given a specified risk tolerance, would reduce private equity exposure.” The firm still believes these assets to be solid investments over time, he adds.

With traditional assets—and, therefore, in traditional asset allocation models—there is an assumption that positive and negative investment returns are equally likely (that is, that they have a normal distribution around the mean, and form a bell curve when graphed). But the research by Citigroup has shown that some investments are skewed negatively, according to Rui de Figueiredo Jr., leader of research for Citigroup Alternative Investments and associate professor at the Haas School of Business at the University of California, Berkeley.

One explanation of this, relating to venture capital in particular, is that when an investment goes awry, there is little to salvage, since the companies involved are so young. With leveraged buyout funds, the businesses already exist and throw off revenues; the private equity fund’s intent is to improve efficiencies and leverage. Even if the latter effort fails, the fund still owns a company with cash flow. “For investors, this does not make these [venture capital] investments unattractive; it just means that they should incorporate these risks into their thinking about how these investments might perform,” argues de Figueiredo. 

Additional Information
Picking Winners