Building for returns

Spotlight on portfolio construction

Naturally, other forms of diversification are also important, especially when it comes to some of Asia’s smaller markets or sector exposure, to avoid concentration risk, as Barzyk explains.

“We are seeking to fund the best ideas, but we also have to look at how adding a manager will affect our overall portfolio,” he says. “So, if we had, say, three of the best technology managers coming to market and we already had a 40% concentration in software, that might not be the best idea for our portfolio. We try to think holistically when selecting managers.”

Diversification – to a point

Some aspects remain constant, precisely because private markets are long-term, usually blind pool, investments. And for many, consistent pacing is a north star in portfolio construction.

“Data tells us that vintage year is among the most statistically significant factors correlated with fund level alpha, so vintage year diversification is key to our portfolio construction,” says Michael Barzyk, Global Head of Private Equity at Allstate Investments.

“I would be remiss to reduce private equity exposure or deployment during more challenging or uncertain times because how would we know ex-ante that these are not going to be among the best vintage years?”

In today’s volatile world, building resilient portfolios has never been more important in private markets, given their long-term investment horizons. So how are LPs going about this?

Given differing objectives and risk tolerance, there are almost as many approaches to constructing a private markets portfolio as there are LPs. But with the recent liquidity squeeze, higher interest rate environment and rise in geopolitical tensions, what are some of the broad trends in the ways LPs are navigating volatility when deciding how and where to allocate their capital?

Liam Coppinger, Head of Private Equity Asia at Manulife Investment Management, takes a similar approach. “For our general account, we aim to match our Asian assets to our Asian liabilities, so our programme is pan-Asian,” he says.

“We never want to be too excited or too disappointed with any one market, so we look at our exposure on a quarterly basis and determine whether we should be adding to certain markets or sectors or whether we already have sufficient coverage and exposure. Then, when we look at adding managers, we ask why we are going to add them and what they will give us. For example, do we need more exposure in Southeast Asia or in the healthcare sector or are we just adding more of the same? Then, we also need to decide if we want to add a new manager or just scale up with an existing one.”

Yet, in a market where the dispersion of outcomes is so high, over-diversification is a sure-fire way of diluting returns, as Meiping Yap, Director – Private Capital at Stonehage Fleming, explains.

“Portfolio diversification is vital. We don’t want to do concentrated bets on specific themes, but we also don’t believe in over-diversifying because then you are just buying the private equity index,” she says.

Settling on the right segments

After a period of heady returns, when increasing multiples and low-cost leverage flattered many managers’ track records, LPs are today seeking out areas where true value creation will drive returns.

“For us, it’s less about what the individual manager can do, and more about the overall portfolio,” explains Joel Sandhu, Partner, TTA Capital & Investors Capital. “So we focus on operational capabilities because that’s where the outperformance comes from. There is nothing special about buying a private company – you have to be able to grow the business, increase its revenue. Multiple arbitrage supported by leverage may have driven returns for 10 to 15 years, but these days, we have to be convinced that managers are taking action to grow EBITDA and revenues.”

And these opportunities, says Yap, can be found in the mid-market buyout and growth spaces. “Private equity is such a broad market, so it’s really important that we focus on the market segments that are truly going to outperform through the cycle and provide attractive illiquidity premia to our investors,” she explains.

“In our view, that’s mid-market buyouts and growth equity globally because these managers can deliver outperformance through the entire investment value chain – buying at below market multiples, driving returns through operational growth and exiting through multiple routes.”

There is nothing special about buying a private company – you have to be able to grow the business, increase its revenue. Multiple arbitrage supported by leverage may have driven returns for 10 to 15 years, but these days, we have to be convinced that managers are taking action to grow EBITDA and revenues.

_{Joel Sandhu Partner, TTA Capital & Investors Capital}

It's also about what you don’t do

While most LPs are following a consistent path in investment pacing and determining the outperforming areas, the more volatile conditions we see today are making investors tread more carefully in certain areas where they perceive higher risk.

“We do make tactical adjustments to our portfolio that are informed by the wider macro picture, including fundraising and DPI levels,” says Barzyk. “This has meant that we have de-emphasised Asia - and China especially – over the past three years. That’s not a permanent shift, but a tactical move in response to underlying macro and geopolitical factors. However, we are still keen to engage with Asian managers because what we hear about the region in the US may not be a true representation of what’s happening on the ground.”

Yap is similarly cautious about the region, albeit because of longer term trends and specific characteristics of Asia’s markets. “We have been investing in Asia since the early 2000s, but we take a measured approach to allocation as the band of outcomes is so large – you can either knock it out of the park or you can significantly underperform,” she says.

“There are FX swings, greater uncertainty on exit windows, geopolitical risk and many other factors. We don’t allocate to Asia for the sake of portfolio diversification, so our Asian managers really need to outperform their US or European counterparts – something we’ve achieved, given our long history of investing in the region.”

Liquidity matters

While liquidity at some point has always been important, the slowdown in exits in many markets and a lack of distributions is causing a headache among many LPs today as funding capital calls and making new investments to maintain vintage year diversification becomes more challenging. Routes to early liquidity are therefore at the forefront of many investors’ portfolio construction plans today.

It’s something family offices have always had to factor in. “We pace ourselves through the cycle,” says Yap. “Our families give us an equal commitment every year so that, by around years seven or eight, the programme becomes self-funding.”

Exposure to private credit is another way of achieving this. “We start from the question of why we are in the business of investing for the family, and the answer to that is that they want to preserve capital and protect it from inflation, while also being able to draw down capital,” says Tuck Meng Yee, CIO, JRT Partners. “Investment pacing is important, but we have to factor in the need for some liquidity, particularly when we have the kinds of issue we see today with DPI more extended than expected. So we have 30% in liquid assets, but we have also built exposure to private credit as a relatively liquid, shorter duration cash flow stream.”

Kerrine Koh, Head of Southeast Asia at Hamilton Lane agrees. “We build portfolios that take into account the desired level of returns, the risk investors can withstand and any liquidity requirements they may have,” she says. “Many of our investors look for an element of liquidity and for these, we’d design a private markets portfolio that would have around 20% to 30% private credit, perhaps more tilted towards the performing or origination side as opposed to distressed or opportunistic because of that need for liquidity.”

Yet there are other options, including secondaries and other fund structures. “If investors want to mitigate the J-curve, we’d design a portfolio that’s heavier on secondaries in the early years of the programme,” adds Koh. “We’d also incorporate closed-ended and open-ended vehicles because especially at the beginning, open-ended vehicles can put money to work fast, while later on, the closed-ended funds’ returns start to kick in. Investors should be open-minded to using all these tools to achieve their objectives.”