Five Considerations When Selecting Private Investments

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Some of the largest college endowments, sovereign wealth funds and pension funds have invested heavily in alternative assets for many years. As an example, Harvard University's endowment fund was allocated in the following way in fiscal year 2023:

Public equity: 11%
Private equity: 39%
Hedge funds: 31%
Real estate: 5%
Natural resources: 1%
Bonds/TIPS: 6%
Other real assets: 2%
Cash and other: 5%

What is noticeable here is the high concentration of assets that are not traded publicly: about 87% of the portfolio. Per Statista, the average distribution of assets managed by public pension funds in 2023 shows about 34% allocated to non-public assets.

Over the last decade, it's been fashionable for financial advisors to recommend some percentage of client portfolios be allocated to alternative investments. In investment-speak, "alternative" simply refers to assets that are less correlated to the traditional stock and bond markets, in terms of risk and/or return measures. But the question is, how practical is this advice, and when does it make the most sense? Here are some considerations:

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1. Do you have enough assets to consider anything outside of liquid, publicly traded investments?

Many people do, but it usually takes professional guidance and financial modeling to determine if this is a viable approach and, if so, what the percentage allocation should be. If you are looking at private investments in real estate, credit (loans), equity, art, etc., you need to be fully aware of how liquid these holdings are. Only that portion of your portfolio that won't be needed for at least 10 years should be considered, as private holdings may be difficult or impossible to sell.

2. Understand the risk and return characteristics of the potential investment.

Risk or standard deviation of returns tends to be much lower for private investments than publicly traded stocks or bonds. This stands to reason, as public investments are valued every second of the day, while private holdings are only precisely valued upon a liquidation event, like a sale or IPO. The potential payoff is that over the 20-year period ending on June 30, 2020, private equity produced average annual returns of 10.48%, while the Russell 2000 index returned 6.69% and the S&P had an average 5.91% rate of return. This comes with an average risk level over the last 10 years of 10.1% for private equity vs 16.2% for the Russell 3000 stock index. Again, this makes sense, as part of that return is due to the "illiquidity premium" that is typically associated with private investments.

3. Patience is a virtue.

For illiquid investments like private equity, the returns typically exhibit a "J curve," which means that the returns are negative in the early years, followed by a rapid increase in future years, assuming you've picked the right investment. Which brings me to the next consideration.

4. Start with funds, not individual holdings.

This is particularly important in the area of venture capital and private equity, as you'd need a huge portfolio to get adequate diversification among private investments if bought individually. That said, the devil is in the details on any potential fund, as expenses and management fees can vary widely, as can the price of the position acquired by the portfolio (particularly among secondary issues that are available for sale). I work with a private investment manager who I trust, as one of his unique skills is negotiating the best pricing for fund holdings.

5. Beware of online platforms that offer funds or individual investments.

With the advent of Regulation Crowdfunding, private issues are now available to practically anyone, as long as you invest no more than the greater of $2,500 or 5% of your income or net worth. If you are an accredited investor or qualified purchaser, the maximums are unlimited. This newer regulation is the impetus behind many online vendors of private real estate, credit and venture capital. Most of these portals are not transparent regarding fees and expenses, so you'll have to dig deep into the offering memorandum and ask lots of questions.

In conclusion, I am a very big proponent of including private holdings in client portfolios, and as a professional investor, I pay a fair amount for research and platforms that provide these types of opportunities to our clients. The variety of investments is truly mind-boggling, as it can range from what we've already covered to investment-grade art. While I believe that the public markets should do most of the heavy lifting in a portfolio, I don't think you should ignore carefully chosen private investments for their return potential and low correlation.

Disclaimer

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

Doug Kinsey is a partner in Artifex Financial Group, a fee-only financial planning and investment management firm in Dayton, Ohio. Doug has over 25 years experience in financial services, and has been a CFP® certificant since 1999. Additionally, he holds the Accredited Investment Fiduciary (AIF®) certification as well as Certified Investment Management Analyst. He received his undergraduate degree from The Ohio State University and his Master's in Management from Harvard University.