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A private equity fund pools capital from investors to buy and manage private companies. The fund’s manager seeks out private companies they believe are undervalued or have growth potential. They invest in these companies, and then use their expertise to improve their operations and profitability, with a view to eventually sell them at a profit. This process can take several years, and the aim is to provide investors with higher returns than traditional stock market investments. However, these funds have their own unique features, with a lock up period, capital calls and often high minimum investment amounts.
Investors might seek exposure to private equity to potentially enhance their portfolio’s overall returns. Over the last 20 years, private equity has outperformed public markets equivalents (McKinsey Global). Its lower volatility is another draw; since private companies aren’t subject to daily market pricing, their valuations don’t swing as wildly, providing a stabilising effect on a portfolio. Moreover, private equity can offer greater diversification, which means spreading investments across various assets to reduce risk. By including assets with returns that aren’t closely correlated with those of traditional stocks and bonds, investors can achieve a more balanced investment mix. This diversity can help mitigate risks and reduce the impact of market downturns on an investor’s portfolio.
Private equity funds have several unique features:
Capital Calls: Investors commit capital up front, but it’s called down as needed for investments. This means the fund has the flexibility to draw on investor commitments over time, rather than taking all the money at once. The investment period can typically last up to 4 years.
J-Curve Effect: Initially, these funds often show negative returns. This is due to upfront fees and the lag time in generating value from investments. Over time, as the companies improve and mature, the value increases, resulting in a J-shaped curve when graphing cumulative returns.
Illiquidity Premium: Due to the long-term nature and lack of quick exit options, private equity investments are illiquid. Investors can’t easily sell their stakes in the fund, which in theory, should reward them with an illiquidity premium — higher returns as compensation for the inability to readily access their capital.
The traditional 60/40 portfolio approach allocates 60% to stocks for growth and 40% to bonds for income and stability. Private equity adds another dimension, offering potential for higher returns and risk diversification, which can lead to a more optimised risk/return balance within modern investment strategies. Historically, the 60/40 split aimed to balance growth and income while tempering volatility. However, in today’s uncertain market, private equity introduces a typically non-correlated asset class that can enhance returns and reduce overall portfolio volatility. It modifies the old paradigm, providing growth opportunities that bonds lack, while potentially offering higher returns than public equities, albeit with higher risk and illiquidity (past performance is not indicative of future performance).
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