Private equity investments can play a pivotal role in diversifying and enhancing your portfolio's returns.

Traditionally, this asset class was accessible only to institutional investors like pension funds and insurance companies. High investment minimums and long lock-up periods kept individual investors out. But, now, access to private equity is opening up to more high-net-worth individuals and private investors, offering an attractive opportunity.

And all the more so now.

So, why Private Equity?

Over the past decade, private markets have experienced exponential growth, with assets under management growing from just under [object Object].

More companies are choosing to stay private longer, with the average age of a new public company increasing from 4.5 years in 1999 to over 12 years in 2020.

Meanwhile, public markets are offering fewer opportunities. The number of listed companies in the US has been declining for nearly 20 years, and the largest companies now occupy a growing share of benchmark indices: the 10 largest companies in the S&P 500 currently account for 34% of the index weight.

As the pool of public companies shrinks and investors grow more comfortable holding private companies longer, innovation and value creation are increasingly being generated by private companies.

So why include private equity investments in a portfolio, and how does it fit with the rest of your investments?

Does it help with portfolio diversification?

By providing exposure to private companies, private equity offers diversification benefits that can complement and stabilize a portfolio, especially when the typical 60/40 (stocks/bonds) allocation becomes less efficient in higher interest and inflationary environments.

The returns from private equity, depending on the exact strategy, can offer lower correlation to public markets, helping reduce overall portfolio volatility.

Indeed, some of the best private equity vintages have been those coinciding with economic slowdowns and recessions. Looking at the chart below, higher returns in 2001 and 2009 overlapped with recessions.

What are the benefits?

Private equity also offers access to opportunities not typically available in public markets, covering companies at various stages of growth and industries undergoing disruption.

This includes everything from early-stage companies developing new space tech to clean energy infrastructure. At EQT, we invest across early-stage venture, growth, and mature buyouts in private equity – covering the whole lifecycle of a business.

This range allows us to spot the emerging technologies that will shape the future of large companies, and pass that insight on to our investors. While small-cap public equities share some dynamics with private equity, the latter tends to have more exposure to high-growth sectors.

For instance, technology is double the weight in private equity compared to the Russell 2000, which has a higher concentration in financials, real estate, and utilities.

Understanding potential returns

Private equity has historically delivered strong returns over longer time horizons, compensating for its illiquidity and risks. The ability of private equity firms to actively manage and improve private companies can generate higher returns compared to passive public market strategies.

Understanding the risks…

That said, private equity exhibits a much wider dispersion in performance compared to public markets.

In other words, potential returns in private equity can be significantly higher or lower. So selecting the right investments and managers is crucial, even more so than with active public strategies.

If you closed your eyes and picked any private equity fund at random, you could be better or worse off by at least 17% in a given year. However, this wide dispersion in performance also presents an opportunity to achieve superior returns when working with top-quartile managers.

The variability in private market fund performance, relative to public markets, can show top-performing funds significantly outperforming public markets.

This underscores the importance of investment selection in private equity.

Building your portfolio

A thoughtful approach to portfolio construction is essential for successful private market investments. Institutional investors like pension funds and endowments typically allocate 5-30% of their portfolios to private equity and other private market assets.

The optimal allocation for each individual depends on your risk tolerance, liquidity needs, investment horizon, and existing portfolio composition. For private wealth investors, a common strategy is to start with a smaller allocation, say 5-10%, and increase it over time.

In general, you should tie your allocation to private equity and other alternatives to your investment goals: what are you trying to achieve with your investments, and what allocation will help you meet those objectives?

The chart below shows that adding a diversified portion of alternatives – such as private equity, real estate, and hedge funds – to traditional stock and bond portfolios can help both manage risk and improve returns.

Structuring the investment

Investors can access private equity through various structures, including funds, fund-of-funds, co-investments, and direct investments in individual companies.

Each has its advantages and drawbacks. Funds provide diversification but come with fees, while direct investments offer higher potential returns but concentrate risk.

In conclusion?

These elements add up to make private equity a key, but often misunderstood component of a diversified investment strategy.

It can open up a universe of new, differentiated investment opportunities, and can significantly enhance returns.

However, allocations should be appropriately sized based on individual circumstances, and a well-structured approach is essential to manage the risks of illiquidity and wider dispersion of performance.

By thoughtfully incorporating private equity into a portfolio, investors can access unique opportunities, achieve higher returns, and enjoy greater diversification, strengthening their overall investment strategy.