Air travel is always more enjoyable when there’s no turbulence. You can say the same about investing – it’s a much smoother and comfortable ride when you can minimize volatility by diversifying your portfolio. However, it’s getting harder to avoid those air pockets when you limit your investments to publicly traded stocks and bonds.
In recent years, equity markets have become increasingly concentrated, with the top seven stocks in the S&P 500 currently representing about 25% of the index. “That’s not diversification,” says Ewa Townsend, Director of Alternatives Strategies at BMO Private Wealth. “The composition of public markets has changed and that’s presenting a different risk in terms of portfolio construction.”
It’s not just that the companies at the top account for a disproportionate share of the index, the entire investing landscape has been shifting in recent decades. As many private business owners can appreciate, private capital is allowing more companies to delay their initial public offering to stay private for longer, says Arthur Diochon, Head of Alternatives Research Canada at BMO Family Office.
If you look at the broader economy, over 80% of companies with revenues of US$100 million or more in the United States are private, explains Townsend. “Even if you want to have exposure to those underlying assets and that value creation, it’s impossible,” she says. “The only way to access it is through private markets.”
Those who access family offices, which often include business owners who have made a significant portion of their wealth in private investments already know the value of this asset class. The challenge has been getting access to high-quality private deals and then finding the time and resources to assess their quality, explains Diochon. Because the asset class is less transparent and has largely been limited to institutional and a select few ultra-high-net-worth investors, it’s been hard to find asset managers who can develop a coherent plan to invest in private equity, he says.
“Ultra high-net-worth clients are shown many deals as they are often leaders in their community, but they lack the resources to assess the quality of these deals,” he says. “Given the timeframe and risks associated with the asset class, they decide it’s generally better to do nothing than try to do it poorly.” At BMO Family Office, Diochon says they are shifting the conversation around private markets to ensure clients receive the support they need.
Improved access to private equity
Private markets span a range of investments, including private equity, private credit, private real estate and infrastructure. Each strategy, or sleeve, serves a different purpose in the portfolio, explains Townsend. “Private equity is the octane for the portfolio that’s supposed to enhance your returns,” she says. “We think of it as an enhancer and diversifier to public equities.”
An investor’s first foray into private markets is normally through private equities because it’s more relatable, notes Diochon. A decade ago, it wasn’t really an option for all high-net-worth investors to access this part of the market due to high investment minimums and lack of quality options, but it’s evolved to offer better, higher-quality offerings that can lower the risk for investors.
Historically, private funds were marketed only to ultra-high-net-worth clients, because they were illiquid, closed-end funds that required investors to commit significant amounts of money for extended periods of time. New innovative products, called evergreen strategies, are breaking down those barriers. These strategies have no fixed termination date and can continuously raise and invest capital.
“The most accessible way to invest in private equity is really through the evergreen strategies, which are these open-ended vehicles that accredited investors can buy, and they’re typically offered by some of the largest providers that you’ll see out there,” says Diochon. “The Hamilton Lanes and Carlyles – your household private equity names – are building solutions that allow clients to invest in a diversified portfolio of private equity investments.” What makes these strategies different is that after a short holding period, investors can typically buy and sell these funds monthly or quarterly within certain parameters.
Enhanced diversification
If you’re considering enhancing your diversification through private equity, you need to know how it fits into your current asset allocation plan. For instance, if you have a portfolio of 60% stocks and 40% bonds, private equity would be considered a sub-allocation within the 60%. The advantage of adding private equity alongside your stocks is that it can enhance your returns and improve your risk profile by reducing volatility. Unlike stocks, which are priced in the market in real time, private equity valuations are only updated periodically, making them less susceptible to wild price swings attributed to sentiment.
The underlying companies in private equity are different from public markets because executives are able to focus on growing the company over the long term, rather than making short-term moves to appease the public market that may not generate the same value over time. “Private equity is a return enhancer, but also a source of access to businesses in a more diversified manner that isn’t available through your regular public markets,” Townsend explains.
Diochon says if he was building a private equity allocation for a client for the first time, he might start around 10% as a minimum of their overall holdings, depending on their risk profile. At that level, there’s the potential to enhance returns modestly, and greatly improve your risk profile, he notes.
Because the evergreen structure can provide liquidity, investors may have the opportunity to adjust their holdings to keep their asset allocation strategically and as opportunities arise, something that would have been an issue in the past given the extended lock-up periods required by most private equity funds. This opens the door for investors who would prefer to have better liquidity in the event they need to cover unexpected expenses.
For ultra-high-net-worth clients, where liquidity is less of a concern, closed-end funds remain part of the conversation as they have the potential to generate even stronger returns. BMO has been expanding these offerings as well. As Diochon explains, BMO Family Office takes a thoughtful approach to integrating private equity funds into the portfolio.
When we build closed-end allocations, we can give clients access to different vintages of private equity funds across a range of geographic areas, he says. “It’s almost like a bond ladder, where different portfolios and companies will have different exits,” he says.
The private market advantage
As much as private equity can help enhance the diversification of a portfolio, the end goal for most investors would be to gain exposure to all private markets, including private credit, private real estate and infrastructure, says Townsend. Private credit, for instance, provides stable income and downside protection, while real assets, like private real estate, provide regular cash flows, upside potential and inflation protection.
Being one of the first firms on the street to onboard private equity funds, BMO has years of experience helping clients navigate these investments. There are a lot of products out there, so it’s important to work with someone who can help you suss out the right options for your portfolio and avoid pitfalls that could prevent you from reaching your goals, notes Diochon.
“We’re not trying to change the destination or the flight path with evergreen private equity, we’re simply trying to reduce turbulence,” he says. “If we can get you to the same spot with fewer bumps along the way, most people would be open to that.”
