Creating a Private Equity Investment Strategy.
Preface
I have previously explored the significant role of private equity in institutional portfolios and its potential to generate strong long-term returns. In this piece, I will distill key insights I've gained into core investment principles, focusing on the essential components of a successful private equity strategy.
This is the second piece of a three part series: 1) Why Invest in Private Equity?
Target High, Above-Average Returns
Private equity returns are expected to be higher than all other asset classes and exhibit less mark-to-market volatility than public equities. By targeting above-average returns, the private equity allocation should be the main driver of overall portfolio returns. Average or below-average private equity performance is not worth the cost of illiquidity, the effort to manage, and the fees paid.
Relationships and Reputation Matter
Success in private equity, like many industries, is driven by relationships and people. Great returns often stem from the expertise, trust, and collaboration between GPs, LPs, and portfolio company management teams, making human capital one of the most important assets. Regular meetings and interactions play a key role in ensuring alignment between all parties—these interactions help assess not just technical capabilities but also the compatibility of values and vision (especially as investment partnerships can operate for 10+ years or longer). Lastly, since private equity is a long game (and challenges may arise), the reputation of the GPs is important—particularly how they treat portfolio company management and LPs in times of crisis.
Focus on the Long-Term
When it comes to building businesses, history demonstrates that quality and duration create an excellent compounding formula. Prioritize GPs who are committed to the long term and who seek the same mindset in portfolio company management teams. While Wall Street often emphasizes short-term gains, this perspective tends to amplify short-term challenges and overreactions to one-off disruptions, making a long-term approach all the more critical for sustained success.
Prioritize a Bottoms-Up Approach
The composition of a private equity portfolio should be driven by bottom-up fundamental analysis and decisions. As an allocator, it is important not to lose sight of the fact that we are investing in companies and management teams, just indirectly through a private equity firm. Thus, it is important not to ignore the underlying businesses held within a GP’s portfolio. In short, seek to invest in excellent companies (business quality) and excellent people (both GPs and portfolio management teams). Although the bottom-up approach is prioritized, the top-down view matters and will impact portfolio construction primarily for risk management and overall diversification purposes.
Develop Investment Criteria
Saying no is just as crucial as saying yes. Clear investment criteria serve as a vital tool for ensuring alignment across the investment team. Investing the time to develop investment criteria can help a team steer clear of investments that may be overly speculative, complex, or uncertain. Over time, the criteria can be refined as more lessons are learned and experience is gained, allowing for continuous improvement and providing a framework for evaluating past decisions.
Be Concentrated
Often, less is more. Investing can easily become overcomplicated, but the approach should remain simple: allocate capital to high-conviction partners and companies that meet well-defined investment criteria. While concentrating on a select group of partners is key, it must be balanced with the advantages of diversification across different partners, geographies, and sectors.
Maintain Rigorous Measurement and Evaluation Standards
Rigorous analysis and evaluation of portfolio company performance, fund performance, firm operations, and key executives should be conducted on an ongoing basis. These metrics can be continuously benchmarked and compared against public market standards to ensure alignment with goals and expectations.
Maintain Disciplined and Steady Commitment Pacing
Certain economic periods can significantly influence specific sectors or segments of the private market, either positively or negatively. The vintage year of a private fund often plays a major role in explaining its overall performance. Maintaining a consistent and steady investment pace helps ensure diversification across different economic cycles and vintage years, mitigating the risks associated with market timing.
Examine Co-Investments and Fees
Co-investing in the highest-conviction ideas of one’s best partners to increase exposure to these higher-return-generating companies may drive the overall performance of the private equity portfolio to above-average levels. In addition, if co-investments can be completed on a fee-free or reduced-fee basis, the fee burden that drags down net returns can be partially mitigated.
Fees are necessary to properly incentivize GPs, but they also serve as a drag on returns. Examine the fee structures to ensure they are set up to maximize long-term returns, not minimize them.
Understand Liquidity Constraints and Cash Flow Requirements
Accurate cash flow forecasting across the entire investment portfolio, particularly within the private equity segment, is essential to ensure sufficient liquidity for: (a) funding charitable contributions, expenses, and operating needs; (b) rebalancing the portfolio; and (c) maintaining investments throughout economic cycles without being forced to sell assets at a discount or below fair market value, or missing out on high-potential return opportunities.