Investors tend to allocate capital by asset class: public equities, traded bonds, private assets, emerging markets and so on.
But this categorisation makes a couple of risky assumptions. First, that correlations between different asset classes stay stable over time. And second, that an asset class’s investment attributes – be it safety or growth, for example – remain constant.
If either of these assumptions proves misguided, efforts at diversification and liquidity management will be compromised. This, in turn, risks decreasing an investment portfolio’s efficiency.
Take the notion that private and listed equities possess different risk profiles. It doesn’t always hold true, particularly when investors hold portfolios with both private equity and small cap stocks – in terms of size and liquidity there’s more overlap between the two categories of assets than investors realise.
The big difference between private equity and small cap listed stocks is returns. Our models estimate that over the coming five years, global small cap stocks will generate annual returns of 8.2 per cent. By contrast, we expect private equity investments to generate 9.5 per cent per year, a premium of 1.3 per cent over small caps (see chart). In other words, investors who substituted private equity for small caps in their portfolios would see a material jump in performance, albeit while giving up liquidity – though this can prove illusory in the market for small caps.
The relative lack of liquidity of small cap equities means that investors hoping to trade such stocks in large volumes are little better off than private equity investors, with block sales and acquisitions tending to take time and discreet marketing to avoid large market impact.
As a result, investors who had both a private equity bucket and significant holdings of small caps in their global stocks allocation would potentially be carrying more liquidity risk than they realised. These investors might do well to rethink overall size of their combined allocation to these two groups of assets in light of their liquidity needs. As an alternative, investors could opt for more mid-market private equity, which offers better diversification to listed equities, if the overall liquidity risk is accepted.
Size effects aren’t at issue either. The major category of private equity is “large buyout”, which encompasses companies worth some USD100 million to USD2 billion. As it happens, that size range is almost identical that of small-cap companies, which typically have capitalisations of between USD250m and USD2bn.
To avoid transactional and operational costs, the holding period for small companies tends to be longer than larger cap counterparts, which, in effect, locks investors up, until the underlying return compensates them enough to realise the notional value of the holdings. That’s to say, there is considerable overlap between small cap stocks and private equity.
The fact that size and liquidity aren’t differentiating factors in relative performance of private equity and listed small cap stocks highlights the importance of company selection – picking companies that can be improved – restructuring and improving operational performance in generating investment returns. In other words, more active investment matters.
There are similarly good reasons for investors in credit instruments to look to private markets – not least the dearth of traded corporate bonds being issued. For investors wanting to build credit portfolios, mixing both private and publicly traded credits helps to build broader, more diversified exposures; direct lending to companies which would otherwise find it difficult to raise capital also offers better yields.
Private equity excess returns relative to small cap stocks, percentage points
Source: Refinitiv, Bloomberg, Burgiss. Data from 31.12.2006 to 31.12.2023.
We modelled the performance of PE relative to small cap as a factor of the level of US 10y Treasury yields, change in relative leverage levels (debt/EBITDA, lagged one year), and change in relative multiples (P/EBITDA). The resulting modelled alpha is added to our team’s 5 year annualised forecast for global small cap returns of 8.2% .
The portfolio as a whole
The total portfolio approach, which has been adopted by a handful of large sovereign wealth funds and endowments, seeks to avoid the pitfalls that come with allocating investments by asset class alone. Rather than sticking to these labels, the approach constantly compares the underlying characteristics of each category of investment and then allocates according to pre-defined investment constraints.
In this way, investors can better control for interactions between assets and correlations in various market environments -- for instance, some instruments will be relatively uncorrelated most of the time but then become highly correlated in periods of crisis. Portfolios can then be constructed in a coherent, consistent and logical way, based on liquidity, income and risk preferences.
That’s the approach we’ve always taken in our Dynamic Asset Allocation strategy. It has allowed us to take concentrated positions within asset classes, knowing that the overall portfolio approach allows us to diversify these, rather than having to water down our main convictions by always diversifying within each investment bucket.
We approach private assets allocation within the context of our other investments, where their interactions, return and diversification attributes are viewed holistically. In our experience this dynamic approach targeting outcomes is more effective than relying solely on strategic allocation.
