These are negotiated private investments in mostly non-public companies at different stages of maturity with the objective of reselling at a higher price in the future. Private equity funds acquire control of companies to increase the market value of their pooled capital through active engagement and exit at a later stage at a profit. This engagement may include demands for changes in management, the composition of the board, dividend policies, company strategy, company capital structure and acquisition/disposal plans. Private equity is an extremely heterogeneous asset class with many sub-sectors. These sub-sectors (e.g. distressed investing, buyouts and venture capital, mezzanine finance, special situations funds etc.) have very different asset characteristics. This means that each subsector has different performance drivers, which investors need to understand to make informed decisions. Private equity is an illiquid long-term asset class, which, when approached with the necessary expertise, has the potential to improve the risk / return characteristics of an investment portfolio.
Allocating to private equity is especially difficult for investors only control capital commitments, and not investment levels. The timing and size of capital calls and cash distributions may fluctuate. The size of one's private equity allocation is uncertain, since valuation of private equity investments is imprecise. Rebalancing is difficult given long lock-ups. Allocating means contending with inconsistent valuation methods. Establishing a target allocation to private equity is challenging because one cannot trade in and out of them at will. Maintaining a target allocation is also challenging, since one must contend with uncertainty in investment valuations as well as estimate the magnitude and timing of capital calls and future distributions. Often returns measurements are a mix of cash-on-cash and current valuations, are not marked-to-market, implying 'stale' prices. Historical returns are not meaningful. Different private equity sub-classes are sensitive to varying levels of leverage. Private equity data does not accurately reflect, what we believe to be, are more accurate correlations and volatilities.
Our approach incorporates information resident in existing returns data, eliminates serial correlation, filters out remaining systematic error and accounts for liquidity risk in private markets. In our view, this process leads to more reasonable and accurate estimates of risk and correlations that serve as inputs into the asset allocation process. Our proprietary “marked-to-market” model yields a better picture of risks and diversification benefits.