Is private equity a worthwhile asset class and, if so, how should one go about building exposure to it? 

The first answer to this two-part question is simple: Yes.

Using a sophisticated returns metric known as a modified Public Market Equivalent—essentially replicating private investment performance under public market conditions, by purchasing and selling a public index’s shares in synchronization with a private fund cash flow schedule—Cambridge Associates has found that US PE and VC have both outperformed US public equities over the past five-, 15-, and 25-year periods. This means that every investor, big or small, should have some allocation to private assets to complement their more traditional assets. 

Striking a balance


That’s the easy part. But what exactly is an optimum allocation, and, once decided, how should investors approach achieving that target?

This will obviously depend on the type of investor, their time horizon, objectives, risk appetite, and their upcoming liabilities. A pension fund having to pay out to a generation of retiring baby boomers may need greater liquidity than a single family office. One size does not fit all.

Some data to illustrate how a higher allocation is likely to play out on average will help here. Cambridge Associates has found that, over the past decade, the median return for institutions with a private investment allocation of 30% or more outperformed the median of those with an allocation of 10% or less, by 200 basis points. That might be expected.

Even more impressively,  the median return of investors with the highest private investment allocations was higher than the top return of investors with allocations below 10%.

What we can say here, then, is that having greater exposure to private capital strategies is likely to result in a better-performing portfolio. Naturally, this isn’t guaranteed. Fund manager selection, timing, and some degree of luck will play their role. But, on average, this is what the data show.

And there are better and worse ways to achieve this exposure.

J-curve ball


One feature of PE that investors are less keen on (and a major reason why secondaries have become such a mainstream strategy) is the J-curve.

Seasoned LPs won’t need this explanation, but for the uninitiated, it takes time for investors in private equity to see any profits. Their capital is committed to the fund, drawn down as and when the manager finds deals to invest in, and then there’s a waiting period while the portfolio company is held and eventually sold. It may take three or four years before investors see any money. This means that returns are negative early in the life of a fund, before swinging sharply to the upside in the second half of a fund’s life.

This idiosyncrasy can mess with the psychology of investors, especially those only beginning to build a PE program. Because they want to see if the strategy is delivering results, they may be prone to dip a toe in the water with a small allocation, with the hope of raising their target allocation to something more meaningful once the strategy has proven itself.

This is a big red flag. All this softly-softly approach does is push the J-curve further out—the PE exposure not delivering positive results until much later. As per Cambridge Associates:

Increasing the target at a future date almost inevitably extends the J-curve. Fully committing to a program from the outset can allow for an increased likelihood of success and requires an intentional long-term allocation target, a well-defined governance process, and a long-term horizon. 

In other words, if the ultimate goal is to have a PE allocation of 10%, then 10% of the portfolio should be invested into the asset class from day one—following a clearly defined, carefully thought out investment strategy and not investing willy-nilly, of course.

This has an added advantage, too. Those with a historically higher allocation to private investments find that, in due course, the program becomes self-funding, such that their capital distributions cover their commitments to new funds. The sooner an investor fulfills their target allocation, the quicker they’ll reach this virtuous self-funding cycle.