Investor education series: Direct private equity investing #3

This series of articles aims to give investors a taste for the different measurement methods that professionals use, what some reputable historical studies say might be reasonable returns for this asset class and some tips on how to create a portfolio with the best chance of achieving them.

See Part 1 on calculating private equity returns here and Part 2 on asset class returns here.

Blog 3: Private Equity Diversification and Portfolio Construction

Issues
The portfolio construction process plays an important part in your ability to achieve a return close to that of the wider asset class. But, it should be looked at within the context of real world private market structures and deal flow. Generally, equity in these companies aren't traded regularly, which means investment opportunities come up infrequently and require quick decision-making and capital availability. Therefore, an investor with a large lump sum to put into private markets must be patient. Because, they not only have to find opportunities they think are worth pursuing, but they must be disciplined not to chase after the first few that come along, or get distracted by other asset classes.

Diversification over time
Like fine wine, a vintage year is important in the context of private equity investment and refers to the year in which the firm began making investments. The vintage year of a fund is significant due to its influence on the economic cycle for company growth prospects and likely effect on the valuations the fund either pays or might receive for businesses.
In private investment, this provides a case for spreading one's exposure to this asset class over a number of years as a way to further diversify. Dollar-cost-averaging aims to achieve a similar effect in the public markets.

Diversification across companies
The key goal of diversification is to reduce the non-systematic risk (company risk) in your portfolio down towards the unavoidable level of overall systematic risk (market risk) in the asset class. There is a wide variety of advice out there on how diversified a portfolio of private companies needs to be in order to achieve this.
The below provides relevant analysis for a New Zealand investor looking at private growth companies:

• "The Intelligent Investor" book by Ben Graham popularised the idea that 15 holdings is the minimum number at which portfolios in the public markets start to track the overall market (although when the book was first published in 1949, there were fewer companies listed).
• In 2010, Kevin Dick from Right Side Capital ran a Monte Carlo statistical simulation of angel investments which suggested that for an individual, 30 investments would give a 50 per cent chance of matching 75 per cent of the market return.
• In 2012, Willamette University professor Robert Wiltbank who worked on The Kauffman Foundation backed Angel Investor Performance Project recommended that angel investors target at least 12 investments.
• Simeon Simeonov analysed the Kauffman angel data and concluded that 25 investments gave a 75% chance of a 2x return.
• Kevin Dick's analysis of the Kaufman angel data in 2013 suggested that 15 investments gave a 70% chance of a 2x return.
• New York venture capital firm FF VC analysed the Kaufman data themselves and concluded that 20 investments is the target number required for angel investors focused on seed stage investments.

Dry powder ratio
Investors who only invest in each company once and do not "follow on" are optimising for the widest possible diversification. A more common strategy in institutional venture capital and private equity investing is to hold back some "dry powder" to "double down" on any companies that are growing well and raise additional capital. This strategy of "following your winners" weights the portfolio more towards companies that are progressing well. Your prior investment also means that you have more information on the company's progress than new investors, so you benefit from making a more informed investment decision. However, an investor shouldn't mistake additional information as necessarily being a predictor of success.

Diversification across asset classes
Modern portfolio theory suggests that investors should be diversified across many asset classes to maximise return for a given level of acceptable risk. This level of acceptable risk is determined by their willingness (risk appetite) and ability (net worth, liquidity needs, time horizon) to take investment risk. Private equity investments can provide another source of overall portfolio diversification by being less correlated with the return drivers of other asset classes in the portfolio. Generally, private equity and venture capital investments come under the umbrella of 'alternative' asset classes (like Real Estate & Commodities) for professional investors. Plenty of literature and professional advice has been proffered with the correct percentage to allocate to these from 5 - 10% of an individual's investment portfolio to over 15%, with no 'correct' answer established as yet. Any decision in this area should be made in the context of your own personal situation and ideally with input from an industry professional.

Limits of diversification
Robert Wiltbank wrote in TechCrunch that "Each investment has to be done as though it's your only one; the bar can't be lowered to enable you to more quickly build a bad portfolio." Even with the evidence for diversification listed above, there are counter arguments that diversification doesn't work as well for early-stage investments and that the best way to generate meaningful returns is to look for companies where you can actively add additional value to the investment or where you have extra information about the industry that makes you able to better assess opportunities versus other investors.