Picking a vintage
So, why the wine analogy?
For private equity, each fund is launched in a given year or “vintage year”, and the performance of a “fund vintage” is dependent not only on the prevailing market conditions.
Like wine, the quality of vintage will also be affected by the opportunity’s quality (the soil conditions), which is set during the investment phase, and the quality of the environment during the harvest period when companies are sold (the weather).
Given these variables, it’s hard to predict whether a particular wine or fund vintage will be a success or not.
A popular debate is whether valuations in private investments are inflated (after the equity market correction) because they are not exposed to day-to-day fluctuations, or if it’s sensible to put capital to work in private equity if listed equity markets have further to fall.
But just like investing in listed equities, timing private markets is almost impossible.
Indeed, fund vintages in the three years before the global financial crisis fared far worse than the investments made during those key problem years of 2008 and 2009, as they were often fully invested as the market turned down. But on the other hand, some of the best performing funds have been raised during market downturns, giving them large amounts of capital ready to invest as valuations decline.
And while analysis from alternatives firm Hamilton Lane shows private market valuations remain expensive, it notes that private equity has been trading at a discount (or cheaper) to public equities for some years.
Relative to history, private equity valuations are also less extreme. Moreover, data since 1990 suggests private equity has outperformed listed markets by a greater extent during periods of low or average returns, such as we are now experiencing.
The importance of diversification
Appropriate portfolio diversification should involve maintaining exposure to private equity through the cycle and across different vintage years.
So, how should we ensure vintage diversification? This can be difficult, because fund structures are often designed to suit large institutions rather than private clients. To address this, there are two paths investors should consider.
First, invest in an already diversified solution. Significant innovation has occurred in recent years, enabling private clients to invest in highly diversified private market solutions in an open-end or “evergreen” format.
These solutions are typically developed by leading allocators of private capital, with significant volumes of high-quality deal flow sourced from multiple years, helping investors address challenges around vintage diversification.
Second, build a road map for your portfolio. Understand where your private equity portfolio is today and where you want it to be.
Try to avoid being heavily biased towards recent vintages or concentrated in particular themes. A good road map should include an annual commitment strategy per vintage to reach your target allocation, and a clear plan to diversify across managers and themes in the years ahead.