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The dramatic decline in public markets in 2022 left many portfolios with above-target allocations to private assets, which, based on what I have heard from asset owners, were barely marked down at all. This has raised questions about governance among asset owners and their boards, particularly around whether and how to adjust the pace of future private equity commitments. In this note, I outline a few possible responses and consider the pros and cons of each.
Figure 1 shows an illustrative portfolio with allocations of 50% to public equity, 20% to private equity, 20% to fixed income, and 10% to private real estate. On the right side, the public market assets have been marked down roughly in line with market performance during the first nine months of 2022, while the private market assets have not been marked down. The result, shown in the last row, is that illiquid assets have risen from 30% of the portfolio to 36%. Private equity, in particular, has risen from 20% to 24%, which might well be above the permissible range for some asset owners.
Of course, maintaining an “over target” private equity allocation may not be a big problem for some asset owners if it’s a result of positions not being marked to market. In fact, I’d note a bit of a paradox in the current situation: If one did mark down the private assets in our illustrative portfolio in line with public markets, the overall portfolio would be worse off (down 22% rather than 15%), but the size of the private allocations would be about in line with where they started the year — and, in fact, the portfolio would be underallocated to private equity relative to where it started the year, as a result of equities having underperformed bonds over this period (Figure 2). Some might ask whether these assumptions are fair, but I think they reflect the fact that if asset owners needed to liquidate private equity holdings to rebalance, finding a buyer on the secondary market would likely mean accepting a valuation marked down by something close to a market return.
Being over target on privates can be uncomfortable. Because these assets are illiquid, imbalances can’t be easily corrected. The long lag between when capital is committed and when it is called means exposures evolve only gradually — and it also means commitment decisions today can have an impact on a portfolio over many years. In thinking about the course of action for asset owners who are over their target on private equity, I see three potential responses:
1. Continue to allocate at the pace prior to the 2022 market drawdown
Advantages: This may put more capital to work today at lower valuations. Our research also shows that there have historically been strong private equity vintages in crisis years as well as the one to three years following a market downturn. The premise is that during times of disruption, well-positioned general partners may act as liquidity providers and make timely investments at attractive valuations. Continuing the prior pace should also position asset owners well if the market bounces back to its pre-2022 levels in fairly short order.
Disadvantages: This approach may put strain on a portfolio’s overall liquid/illiquid balance, especially if markets experience another leg down. Investors may be locking themselves into commitments that turn out to be disproportionate relative to their asset base at the end of 2023 or 2024.
2. Cut private equity commitments substantially, with a focus on bringing allocations back to target
Advantages: This approach most directly addresses governance concerns about being overallocated to private equity, and the portfolio should be positioned relatively well if markets fall further. There should also be a greater margin of safety if the pace of capital returns slows (we may be in a period where private equity distributions slow somewhat, affecting those who rely on the distributions to fund future capital calls).
Disadvantages: If markets bounce back, asset owners taking this approach could find themselves with a meaningful private equity underweight for an extended period. They may also find they missed an opportunity to put capital to work at compelling valuations. Investors should recognize they still face the risk of remaining overweight private equity even after taking this step, given the slow pace at which private equity allocations evolve.
3. Decrease future commitments in line with the overall portfolio’s new size
Advantages: This approach avoids pulling back too dramatically when valuations are compelling while still accounting for today’s market realities and the risks of being overallocated to private equity over time.
Disadvantages: This option could create a missed opportunity if markets enjoy a strong rally while upcoming commitments are being reined in. On the other hand, this approach would take some time and until the desired private equity exposure is achieved, the portfolio may still be exposed to liquidity challenges if markets sell off further.
Asset owners will have to take their specific goals and risk tolerances into account, but I would tend to favor the third option — adjusting commitments going forward, based on the new portfolio size. I think this provides flexibility and a good balance between the upside and downside risks of the other two approaches.
I would offer a few other considerations for asset owners navigating the denominator effect. First, be aware that existing investments in a private equity portfolio may be affected by the rising cost of capital in today’s market. Companies held in a leveraged buyout portfolio, for example, may need to roll over their financing at some point and investors may take a “haircut” as a result.
Second, as noted earlier, it could be helpful to prepare for the possibility that if markets continue to be challenged over the next 12 to 18 months, the pace of capital returned may slow while the pace of capital being called accelerates.
Finally, I think it’s worth remembering that increasing one’s private asset target is also an option and one that has come up in a number of my conversations with asset owners. It’s a way to address some of the governance concerns while reducing the pressure for a draconian response to being overweight private equity. That said, a decision to raise a policy target likely warrants some stress testing to understand the potential implications of another leg down in the public market — a topic I’ll cover in an upcoming article.
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