Key points:
● Understanding your investment objectives is crucial to building a private market portfolio. Your investment objectives need to be reflected in the asset classes and strategies you decide to include in your portfolio to achieve success.
● Institutional investors use models to help them determine the optimal amount of money they should invest in each asset class or strategy that is consistent with their investment objectives. Individuals do not need to replicate the models as the underlying principle of seeking diversity across all dimensions of investment characteristics remains as is the consistency of building a portfolio aligned with your investment objectives.
Introduction
In previous posts, we introduced the world of private markets and explained why investors should consider accessing them. Today we discuss the next step on your journey - constructing a successful private markets portfolio that is aligned with your investment objectives. We will delve into insights on how institutional investors construct portfolios and discuss a simpler approach for you to build your own private markets portfolio.
Understanding your investment goals
Before we jump into the portfolio construction tips, it is worth spending time to reflect on your overall investment goals as a wholesale investor. Whether your focus is on retirement, education funding, or building generational wealth, aligning your portfolio with your objectives is fundamental to building a successful portfolio. There is no one-size-fits-all solution; it's about crafting a strategy that considers your risk tolerance, investment horizon, and personal circumstances.
To do this ask yourself these key questions:
● When do I need cash and how much cash do I need annually?
● What is my investment horizon?
● What returns do I need to meet my goals?
● What is my overall risk tolerance level?
● Do I have specific views on global or economic themes that I would like to express in my portfolio?
● Am I comfortable with the administration and operational processes of investing?
● If I invest in private markets, what will this replace in my portfolio?
With the exception of the last question, these questions are personal and only you can answer them. They help to set the parameters and criteria that you can use to help determine the type of strategies and investment opportunities that may be appropriate for you. Then as investment opportunities arise your goal will be to understand their characteristics and features and then assess whether they are expected to get you closer to achieving your investment objectives.
If you have a trusted financial adviser it would be best to include them in this conversation or find one if you want to talk to someone about helping you to tease out and define your financial objectives and needs.
The institutional approach
The process of setting your investment objectives is no different to what institutional investors do, they just do it on a larger scale and in more granular detail. It is in the process of deciding how much to allocate into different asset classes and strategies which differentiates what institutional investors do versus what we do as individual investors.
Institutional investors take a scientific approach to determining how much to allocate to a particular asset class or strategy. This requires assumptions to be made about expected returns, volatility and correlations for each asset class. They then feed these assumptions into models that determine the optimal allocations (i.e. highest return for a particular level of risk) to each asset class or investment strategy. Their model also considers the investment parameters and criteria that were determined in the investment objectives setting process (i.e. it will limit the amount that is allocated to illiquid assets, it will make sure that the target level of income is achieved if that is a priority, it will limit the amount that is invested domestically to make sure there is sufficient geographic diversification etc).
Replicating this process is not necessary as the underlying assumptions always turn out to be incorrect. But underpinning that process and what remains as a key principle of portfolio construction is that diversification across various investment characteristics is crucial for better risk-return profiles.
Applying the institutional insights to your portfolio
So how do you apply this insight to your own investment portfolio?
1. Decide how much illiquidity you can handle
Generally speaking the longer your investment horizon the greater level of illiquidity you can handle. For example, when I am considering my superannuation investments I'm comfortable having a high level of illiquidity since my superannuation can't be accessed until I'm 67 and that is a couple of decades away. Depending on your own situation and how much liquidity you need I suspect most investors are going to have a smaller allocation than that. While there is no single "correct" answer there are "incorrect" answers and I've seen institutional illiquidity limits range from 0% (for funds in the pension phases, meaning that their main focus is on income generation) to 70% for more long-term endowment style funds. If you're not sure how much illiquidity you can handle, seek professional help from an appropriate adviser.
2. Consider what returns you need from your total portfolio to meet your investment objectives
Ask what sort of returns am I trying to achieve, if you only need a 3% return then seeking high-return/high-risk investments like venture capital or private equity are likely to be inappropriate at a time when cash rates are hitting almost 5% p.a. On the other hand, if you’re looking for low double-digit returns then a mixture of all the private markets asset classes is probably going to work best. But if you’re looking for mid-teens or higher then you are going to have to seek the higher return and risk potential asset classes like venture capital and private equity. The exact mix of strategies and funds will then depend on the investment parameters and criteria you set earlier like the desired returns from the asset classes, your risk tolerance and your investment thematics. What you can then do is use the target return expectations that will typically be provided in the fund investment memorandums to determine the percentage allocations for each of the different strategies you are considering.[1]
3. Get that diversification across asset classes, and strategies, and don't forget vintage years
It’s important that you don’t invest your entire allocation to private markets in a single year, which is known in the industry as a vintage, for example, private market funds that closed in 2023 will be known as a 2023 vintage. Like diversification across strategies and funds, you will also want to diversify across vintages.
While funds and strategies typically raise every three to four years, your private market allocation can be dynamic. For example, commiting 25-30% of your total allocation to private markets in a given year may provide a good starting point but can be adjusted based on individual circumstances. This is not a hard and fast rule. You may wish to increase or decrease this pace of investment commitments depending on the opportunities you see available and also depending on the distributions you receive back from prior vintages you have committed to.
4. Consider evergreen funds if you don't want to manage cash flows, but be aware that it comes at a cost
If managing cashflows and commitments is not your preference, evergreen private market funds might be a suitable option. Evergreen private market funds don't have an end date like the traditional closed-end funds and you do not have to commit to new funds each year as older vintage funds wind down. Instead, you will have to monitor the performance of the evergreen fund and periodically assess whether it continues to be an appropriate strategy for you to invest in. Note also that there is also a trade-off between investment performance and ease of administration when it comes to evergreen funds as the fund manager will typically hold more cash than in a closed-end structure (but that is a story for another post).
These tips are simple to implement and their combination will set a strong foundation for you to build a private markets portfolio that works for you.
Up Next
This post concludes our introductory series on private market investments, but our journey doesn't end here. In our next series, we will explore the diverse strategies in private markets that span the spectrum of risk, return, and liquidity profiles. Stay tuned as we continue to demystify private market investments.
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[1] Returns are not guaranteed and the value of investment may even decrease.