Private investment is also known as an alternative investment. It is a financial asset that is not available in the public markets, such as stocks, bonds, and cash. An investment fund is a way for qualified investors to access private investments. Private credit, real property, natural resources, and infrastructure are all examples of sectors that can be accessed through private investment funds.
Private investment assets under management increased from $4.1 trillion to $13.8 trillion between 2010 and 2022, which is relatively small in comparison to the total capitalization of public markets. It is expected that this figure will grow to $17.2 trillion by 2025. On a dollar-weighted basis, institutions have seen a significant increase in their allocation to private investments. It went from 27.7% in 2003 up to 59% by 2022. According to KKR surveys, high-net-worth investors increased their allocations to private investments by 26% in 2021 and 29% in 2022.
What role does private investment play in investor portfolios, as qualified investors are becoming more popular?
How can private investment improve an investment portfolio?
Private investments are a great way for qualified investors to diversify, decrease portfolio volatility, increase risk-adjusted return, and achieve high absolute returns. Private investments are attractive to institutional investors for their diversification benefits.
Modern Portfolio Theory suggests that an investor can increase the risk-return ratio of their investment portfolio by investing in specific assets or sectors with low correlations. Low-correlation assets have different returns in relation to one another.
This reasoning suggests that private investments with a low correlation to public markets offer investors the chance to diversify their portfolios, which can be interpreted as reducing portfolio volatility and overall risk exposure (idiosyncratic risks).
Private investments may also provide higher returns than the public market because there are fewer investment restrictions for fund managers and investors have access to a larger investment pool.
Hedge funds, for example, invest primarily only in the public market but can also use less common, more sophisticated strategies such as short-selling, derivatives, and leverage. Venture equity also allows investors to invest in equity at the very beginning stages of private companies, something that is not possible for those who only invest in the public markets.
These potential benefits are offset by the higher risk associated with private investment funds, as discussed below.
What are the risks associated with private investments?
Private investments have different risks than the public market. Private investments are less regulated, less transparent, and less liquid, and have to be called on a regular basis for funding.
Private investments are less controlled than the public market.
Private investment funds, for example, are not required by law to report publicly their investment returns or positions. Potential investors may not have access to all information, so it is important that they do extensive due diligence.
Investment managers can also use riskier strategies and more complicated legal structures without regulation, which allows them to keep their returns and strategies private. Private investments are restricted to institutions, accredited investors, and qualified purchasers because of the lack of transparency and regulation.
Investors are also at risk from liquidity, both at the fund and limited partner levels. The term of private investment funds can vary from 3-10 years depending on their strategy. Hedge funds are the exception, offering partial or full liquidity after a year at either monthly or quarterly intervals, for example. Private investment asset markets are often scarce or non-existent during the term, making it difficult to liquidate funds in times of economic stress.
Private investment generally makes a limited partner's capital illiquid. Investors need to be proactive about managing their liquidity. If an investor has a liquidity problem and all of their capital is held in illiquid investments, problems could occur as this is not the best way to invest money.
Private investments are also highly liquid, which can lead to rebalancing risks. It is usually impossible to reduce a portfolio that has become too concentrated in one sector or strategy for private investors.
Capital committed to private investment funds is generally not called at once. Fund managers will ask for capital when investment opportunities arise. This can sometimes be sporadic and could lead to capital waiting to be called. It is therefore important to manage capital inflows and outflows so that sufficient capital is available when requested by a fund manager.
Market downturns can lead to funding risks. Portfolio investments might require more capital than the original capital commitment.
Private investments are restricted to qualified purchasers and accredited investors because of these risk characteristics. It is possible to partially reduce some of these risk factors, however.
These risks can be reduced.
You can have a risk and still enjoy a concurrent advantage.
A lack of information, small asset markets, and limited pricing options can lead to greater pricing inefficiencies than what is available on the public market. Active management can exploit these market inefficiencies. It is, therefore, important to assess the experience and ability of an investment manager to implement a given strategy.
You can reduce illiquidity by investing in private investment strategies that make regular distributions over the life of the fund, usually quarterly.
Some strategies also use an evergreen fund structure, which allows partial or full withdrawal of capital after 1-3 years. An evergreen fund has the disadvantage that it is fully funded upfront regardless of whether there are investment opportunities available.
What factors are important in determining suitability?
Private funds can be used to improve the risk-return profile of a portfolio. We believe that the most important factors to consider include the investor's tolerance for risk, liquidity needs, time frame, and investment goals. To ensure sufficient liquidity, it is important to know how to invest in a private company and do extensive due diligence to find the right managers.
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