Private Equity Allocation Considerations: Unveiling Key Characteristics

In the ever-evolving landscape of investment strategies, investors face an ongoing challenge – how to optimize equity returns. During the allocation process, investors seeking return enhancers have considered private equity or venture capital fund managers (combined “private equity”) and public equity fund managers. While the tides have changed recently, over the past three decades, investors have been drawn to the allure of private equity as a promising avenue to augment their investment returns.

People may think they know about private equity, but it is elusive in many ways, which makes it difficult to compare it to public equities. As such, we have put together this educational paper on private equity investments to help provide more clarity on the asset class so that investors can make a more informed decision.

Private Equity Funds Summary

Private equity funds, including venture capital, pursue profits by acquiring ownership stakes in private companies, aiming to sell them at a higher value than the initial investment—a strategy encapsulated as "buy low, grow fast, sell high." This approach resembles the stock market, but instead of trading public equity liquid stocks, private equity has a long holding period with considerably less transparency and regulations.

Two Key Factors That Differentiate Private Equity Fund Strategies:

Stages of Investment

Venture capital funds invest in the early to growth stage of a company in smaller transaction sizes. These companies, depending on the stage or series of rounds, are extremely small, with Series A being ~<$500K in revenue to ~$10M in revenue for Series C. In comparison, private equity firms invest in companies that are in the growth and expansion stage of their life cycle, are more established, are closer to an exit, and raising larger transaction sizes. These are better-established companies with typical revenues of over $100M. In the past, private equity and public equity markets used to complete more head-to-head deals, but that trend slowed down as more companies waited longer to go public. The later the stage, the more de-risked the investments.

Industry and Regional Specialty¹

Funds with more localized specialization, industry know-how, and greater networks can:

1. access key deals, 
2. conduct more nuanced due diligence, 
3. provide more industry support during harvesting/active management, and 
4. network for acquisition exits. 

Important Considerations When Investing In PE and VC

High Startup Failure Rates ²

On average, 81.2% of companies that received at least a seed round never see an exit; therefore, investors never realize any return on their investment. As a startup advances through its financing stages, the likelihood of failure to exit declines as more advanced companies in the financing sequence tend to be more mature and established, increasing its chances of a successful exit.

Venture Capital, The Law of Numbers Problem³

What is the optimal number of investments in a typical venture capital portfolio?

There are two trains of thought.

1. Concentration: “One of the benefits of a more concentrated portfolio is that while it does increase risk, it also increases potential gains. Investment portfolios that obtain the highest returns for investors are not usually widely diversified.”⁴ Based on the classic portfolio theory, diversifying public equities can be effectively achieved by combining a portfolio of 20 to 30 stocks. Recent studies reveal that a more optimal diversification strategy involves 40 to 70 stocks.⁵
2. Diversification: The significance of investing in low probability (high failure rate) and high-return opportunities (outsized returns on "home run") necessitates a well-diversified portfolio of hundreds of companies to significantly decrease risk and create a tighter dispersion of returns.

In a concentrated portfolio, there is a large dispersion between the top- and bottom-quartile funds, with a median return of around 10 percent. With a portfolio size of 500 investments, the dispersion for returns tightens to a range of 10 to 17 percent with a 13.5 percent median return. This range of returns from bottom to top quartile is similar in size to that of public equity funds; however, they do carry a long lock up.⁶

Reasons for diversification: All the returns come from a staggering few or one winner. ⁷

• Failure rate: Due to the high failure rates, the ending portfolio size is about one-third of its invested companies. Therefore, to achieve exposure to 20 to 70 companies, a fund must initially hold a portfolio of 60 to 210 startup investments.
• Outsized returns: To reliably tap into the excess returns generated by one in approximately 250 deals, you need to increase the size to around 500 investments. According to Correlation Ventures, when you consider the statistic that 0.4% of deals return 50x the invested capital or more, which is responsible for around one-fifth of the total cash returned by the industry, taking a chance on anything less might result in a portfolio that lacks those extraordinary winners. See figure on page 6.

Other key statistical considerations:

• Top 25% of funds: There is a wide dispersion amongst venture capital returns. Only the top 25% of venture capital funds provide an IRR over ~10%, with a significant percentage of funds experiencing a permanent loss of capital, unlike public markets where stocks can dip and recover. Furthermore, the bottom quartile of venture capital funds loses money, whereas public equity funds deliver an average return of 5% or higher.
• Portfolio construction: On average, seven out of ten portfolio companies will either not produce a return or must be written off. Therefore, in an imaginary portfolio of ten, two investments must generate returns that will offset any losses; while the third of investments carries the 20% to 30% IRR investors are seeking.
• Private equity funds are closed-ended funds, and a majority of them do not have the AUM to invest broadly.

Why Managers Do Not Diversify

• The top quartile of venture managers is rewarded with further AUM and fees on larger follow-on funds. Managers who diversify to minimize risk will diversify away performance and ultimately strive for returns within the second quartile, resulting in less AUM.
• Building and managing a large, diversified portfolio is hard to do, and most funds are resource-constrained and do not have the AUM nor the people resources to invest in a large pool of companies. 
• Most investors do not request it. A consistent, numbers-driven investment strategy in venture capital lacks the emotional appeal compared to the captivating rock star pitch. “In the world of venture, where deal-by-deal performance data is not widely, reliably, and publicly shared, and where fund-level results take a decade or more to be fully known, rational pitches should be expected to underperform emotional ones.”

Managers Are Stretched Thin

Venture capital firms and, to a lesser extent, private equity firms do not directly engage in the operations of the companies they own or control. They primarily function as financial managers. Over the last decades, fund managers have had less time to focus on portfolio management, and the investment teams are being stretched amongst too many other activities.

(1) Driven by the journey of funds and the pursuit of increasing AUM

Investing in private equity funds involves a prolonged commitment. Unlike liquid equity investments, these funds have definitive lifespans. Typically, they launch with a 10-year period, potentially extendable by the manager for up to two - two years options. This structure implies a 10-14 year horizon. However, these funds may persist well beyond the anticipated timeframe of 14 years from the initial capitalization to eventual liquidation. Additionally, funds tend to go into fundraising on the subsequent funds approximately 3 years into completing raising the prior fund, during the investment phase, dividing up the investment team's time between investment activities and fundraising. In funds older than the third vintage, managers can concurrently be raising capital, investing, and harvesting/active management concurrently. 

Fund managers aim to strike a balance between demonstrating strong performance from the current fund and the need to secure commitments for the next fund. See the fund performance section on Horizon IRR to illustrate utilizing unrealized returns to raise capital for subsequent funds.

(2) Not enough time to invest and manage the portfolio

Harvard Business Review wrote an article on how Venture Capital partners spent their time. Based on their study, “assuming that each partner has a typical portfolio of 10 companies and a 2,000-hour work year, the amount of time spent on each company with each activity is relatively small. If the total time spent with portfolio companies serving as directors and acting as consultants is 40%, then partners spend 800 hours per year with portfolio companies. That allows only 80 hours per year per company—less than two hours per week.” ⁸

Explosion Of Funds and Assets Raised

In 2021, as reported on ADV with the SEC, there were more than 18,000 private equity funds, a 58% increase over the last five years. Meanwhile, the number of venture capital funds increased by 110% to more than 1,700 funds.⁹ Growth in funds has led to increased competition for the same investment opportunities, intensifying the pursuit of high-impact investments and driving up valuations.

Understanding Private Equity Returns

There is a common misconception that private equity and venture capital returns outperform the public stock market. However, the truth is that the returns over the past 15 years have been rather lackluster, often only managing to keep up with the stock market or even falling behind. This is particularly noteworthy when considering the heightened volatility and lack of liquidity associated with private equity funds. According to Johns Hopkins Carey Business School Senior Lecturer Jeffrey C. Hooke, since 2010, more than half of the investments made by PE funds have remained unsold.¹⁰ Unlike publicly traded stocks that are valued every day, investors are left to trust the valuation provided by these PE funds for these lingering investments. PE's highest returns are generated by the top 25% of funds, yet too many funds that fall below claim to be in this top quartile.

Returns

Based on Pitchbook data and our calculations, we estimate annualized net returns of 10.5% over a period of 10 years.¹¹ This is in line with the U.S. Private Equity Index offered by Cambridge Associates, stating private equity generated an average annual return of 10.48% spanning the 20-year period concluding on June 30, 2020.¹²