More often than not, the beginning of an investors private equity “programme” is not well planned or deliberately executed.
Rather, it is based on sentiment, what peers in the market are doing, and what funds are available. Investments and portfolios may consequently suffer from a number of things including: home bias, concentration, ad hoc portfolio construction, and being “managed” in excel.
There are obviously a great number of things that need to be considered, but the first thing I believe an investor, who is new to private equity, should think about is whether they want build a programme in-house or whether they should outsource it.
Here are four areas to consider in this regard.
Risk
The starting point should be your own risk tolerance. How much risk of a drawdown / loss are you willing to take?
Depending on this, and in the context of your return expectations, your strategy / portfolio will have a trade off between concentration and diversification. In regard to risk you also need to consider your governance mechanisms.
Size
Secondly, do you have the critical size for a running a PE programme in-house?
Estimates vary, but a good rule of thumb is that you need at least USD / EUR 300m per strategy / region. Less than this and it may not be economically viable to hire specialists for implementation.
Size also works in reverse. If you are investing several 100m or more per year, you need to consider if your team has the capacity to do so. As critical as it is to have a minimum level of diversification in a portfolio, it is just as critical to avoid creating overly diversified very granular sub-scale portfolios.
Skill
The next consideration is whether you have the skills needed to make the investments. Private equity is still to a very large extent an opaque and skill based asset class and, once invested, you cannot easily get out.
Consequently you need to hire, train, and retain highly qualified specialists to ensure making the best possible investments and limit the risk of any mistakes as much as possible.
Skill should also be considered in the context of your chosen strategy. If your team knows nothing about venture capital or China, they should probably not do either.
And, as attractive and straight forward as they might seem, co-investments and secondaries are very different from primary fund Investments and require a different specialist skill-set.
Access
Finally, you have to consider access. Private equity is not a forgiving asset class, and a sure way to achieve third and fourth quartile returns are to invest with the managers that you can find and that can access.
Can you find / identify the best managers and subsequently invest with them? Today there is an abundance of funds and you can google your way to most of them, but many of the “best” are access constrained and not open to new investors.
Minimum size. larger funds will often have a large, USD 10m or more, minimum commitment, this may be too much for some investors.
Maximum size. In some cases, notably Venture and Growth funds can be quite small. For larger investors it may be prohibitive to make small enough commitments to these funds, all but “locking them out” of a particular strategy.
There is no wrong or right answer. These four areas are obviously interrelated , and being “strong” in one area can offset a “weakness” in another area. But an investor would obviously benefit from being “strong” in all four areas or at least striving to build those capabilities.
Having critically assessed these areas it may be that it makes most sense to keep everything in-house, completely outsource or maybe something in between.
How to approach this, alongside other considerations will be the topics of other posts.
Stay illiquid!
Kasper
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