Trade talks between the US and China have broken down and, once again, we are confronted with the rising risk of an all-out trade war. Just a month ago, expectations of a deal were high and global growth was recovering, so this has heightened the market’s negative reaction to the collapse of trade talks.
We continue to anticipate a US-China trade deal as both Presidents have strong incentives to finalise a deal. We also believe that this current skirmish should not materially damage the global growth outlook, given the combination of low inflation, dovish central banks and renewed Chinese stimulus.
Still, the risk of a political misstep has risen. So we have recently been tactically hedging our position to account for the risk that the US and China simply can’t settle their differences. This includes trimming some of our emerging market equity overweight and reducing our underweight in Australia, where we believe the outlook for housing and the economy has recently improved.
The volatility we are seeing in traditional assets in the later stages of the cycle, along with increased volatility due to geo-political risks, strongly supports significant portfolio allocations to alternative assets such as private equity. Like other alternatives, private equity can increase the return potential of a portfolio and also enhance diversification as they have a lower correlation to broader market swings.
Private equity typically refers to investing in the equity of businesses that are not traded on a public exchange. It generally involves allocating capital to private equity firms that “take private” a company that was previously publicly listed or purchase a family-owned business that is already private. The goal is often to restructure, refocus and revitalize.
What are the key benefits of investing in private equity?
The much higher number of private companies versus publicly listed companies brings a greater opportunity set and is widely seen as an advantage of investing in the asset class. The number of publicly listed companies has also generally been in decline for the past two decades. In addition to providing greater diversity, private equity investments have consistently outperformed listed equities over time and with lower volatility. This is because valuations tend to be less impacted by sentiment-driven swings in public markets.
Where does private equity source its return?
Private equity investments derive their return in much the same way as listed equities. However, private equity managers have an expanded toolkit to drive outperformance. This can include better access to information, improved governance (through control and alignment of interests), an operational, long-term focus, and favourable exit timing. Such tools are often not available in listed equities. Manager return dispersion can also be quite wide, which means manager selection is often a key source of return within fund-of-fund vehicles. Although private equity has a high correlation to listed equities (it can be as high as 0.8), volatility is typically much lower.
Risks?
However, private equity is usually a highly illiquid investment. Once invested, capital often cannot be redeemed for the full term of the investment (often six to 10 years), and returns are often irregular as the fund’s investments are realised. Investments can sometimes be sold on secondary markets, but this can be at a discounted value. However, according to Blackrock, “the cash flows from a successful fund should be positive after a few years, as the fund begins to exit portfolio companies”.
There is a range of risks specific to private equity, though utilising fund-of-fund vehicles rather than a single alternative investment partnership can lower these risks. Private equity strategies are less regulated than publicly offered investments and may exhibit higher operational risk; manager selection is also key. Acquired companies can also be more exposed to specific economic themes and sector events, and failure risk in venture capital is high. Investments can also be vulnerable to “vintage year” risk where private equity managers can at times face acquisitions in an expensive public market environment.
While alternatives such as private equity are considered higher risk than fixed income and cash, they have, historically, generated stronger investment returns over the longer term. Compared to equities, the broad set of alternatives has generated less return but also exhibits less risk.
Scott Haslem, chief investment officer, Crestone Wealth Management
