The proverbial saying goes that “variety is the spice of life”, and is typically used as a reminder to remain open to things that are new and unfamiliar. However, when applied to investing this idiom also speaks directly to the value of portfolio diversification.
An investment technique of allocating capital across a number of different investment types and industries, diversification is used to aid in increasing returns while also decreasing overall risk. Any introduction to investing will inevitably advise on the importance of a diverse portfolio, and today it has become common practice to do so in order to ensure that one’s combined assets result in a higher risk-adjusted return.
There are a number of different ways someone can diversify an investment portfolio. They can invest in an array of assets within an asset class, such as buying the market index to ensure a variety of high- and low-risk stocks across industries are equally represented. Investing in international markets can also mitigate risk by taking singular pressure off the domestic market to perform well.
The third strategy is to diversify by investing across asset classes. Historically, one of the most popular allocation strategies has been to allocate 60 percent in public entities and the remaining 40 percent in bonds, with the aim of achieving more consistent long-term returns while lowering levels of volatility. However, the high inflation, increasing interest rates and high uncertainty we have faced in recent years have served to destabilize this once consistent strategy, and today many investors have been moving away from such models and adding allocations to alternative asset classes such as private equity.
According to Mark Hauser, a private equity investor and fund manager, although it is often assumed otherwise, private equity assets share many features with publicly-listed equities and people should not fear using this alternative investment type to diversify their portfolio. Hauser is the founder and managing partner of Hauser Private Equity, a continuation of the successful strategies he had previously developed for his Hauser Capital Partners private equity fund. In total, Hauser has over 35 years of investing and operating company experience, and over the past fifteen years Hauser Private Equity’s five funds have put over $350 million in capital toward more than 500 investments in total, and realized over 150.
What is private equity?
In general, private equity refers to any ownership or stake in an entity that is not publicly traded or listed. Private equity firms are partnerships that purchase and manage private businesses before releasing them for a profit. These firms will create funds by collecting money from investors and investing in businesses on their behalf. In almost all cases, a private equity firm will either take a controlling stake or purchase the entire company outright.
The businesses in a private equity fund are called their portfolio companies, and firm partners will work with their portfolio companies’ executives to improve the business and facilitate growth. According to Hauser, the relationship between private equity firms and their portfolio companies is unique in that they take an active role in ensuring their investment ends in a profitable exit. Meanwhile, the portfolio companies are able to achieve larger growth at a much more rapid pace than they would have been able to without a private equity firm.
Private equity is often grouped with venture capital, but Hauser said it is important to highlight where they differ. Venture capital firms will typically target startups, early-stage and emerging companies that have been deemed to have high growth potential, or may have already achieved it to some level. Private equity firms on the other hand can have a broader scope, and may decide to invest in a company that is failing or underperforming because due diligence has indicated its problems are resolvable.
Private equity diversification
Hauser said that in recent years institutional investors have begun diversifying towards alternative asset classes such as private equity. Indeed, today market allocations for big institutions such as pension funds, endowments and foundations generally range from 10 percent to 25 percent. While private equity does have some accessibility challenges – those who wish to invest in this asset class must be able to put forward a significant amount of capital for an extended period of time – as the popularity of it grows there will inevitably be a continued evolution of its reachability.
Indeed, the rise of private market asset classes like private equity is assumed to be linked to the declining number of exchange-listed stocks. Since peaking in the 1990s, the number of companies publicly listed on United States exchanges has steadily decreased. As more organizations are able to raise money in the private markets, it’s easier to stay private longer. As long as the pool of exchange-listed companies continues to trend downward, it is safe to say that investors will need to look in new directions in order to robustly diversify their portfolio.
Allocating portfolio space to private equity means that investors will hold a broader and more varied section of the investment landscape. Often companies with a strong potential for performance either have consciously chosen or are not yet ready to enter public markets, and investing in them can spread risk at a lower level, preventing too high of a concentration and improving a portfolio’s overall diversification.
As with all investment decisions, Hauser highlights that allocating private equity into an investment portfolio comes with a degree of risk and requires thoughtful planning and due diligence. Investors would benefit from looking with an overarching perspective at their current portfolio and develop an understanding of how private equity would fit with existing investments. It is important to know how investing in private equity would affect the overall performance as well as volatility of a given portfolio.
While no two portfolios should ever be alike, when adding an entirely new asset class it can be helpful to do research and take inspiration from experienced investors in terms of how much to allocate. The ideal allocation can and should vary depending on a myriad of factors, but an important part of the research process is looking to those with more experience in the asset class and benchmarking where others have landed is a good starting point.
Portfolio diversification is imperative
One of the most important lessons in investing is how to balance risk and reward, and one solid way of doing so is by diversifying. Diversification can help mitigate the risk and volatility in your portfolio, potentially reducing the number and severity of fluctuations. Hauser said that nothing can 100 percent ensure a profit or guarantee against loss, but building a robust portfolio that is fully diversified is one of the simplest ways you can protect yourself and your assets.