Private Markets: 4 steps to help you optimize your allocation to alternatives

Also, while the broad array of investments provides investors great flexibility, it also necessitates an added level of scrutiny, experience and monitoring to uncover all the underlying attributes of each asset class and opportunity.

2. Right-size your alternative investment allocation.

The next critical question for those who already are invested in alternatives: How much capital should I put, in total, to work in the private markets?

The typical range we’ve seen among private bank clients is 15% to 30% of their overall portfolio. That said, some clients with significant resources and an inclination to plan multi-generationally do allocate 50% or more to alternatives; much like some large endowments.

Carefully consider how much you might allocate to help you achieve your particular goals. As part of that decision process, we can help you evaluate your:

  • Tolerance for illiquidity and time horizons—The size of your commitment depends in great part on your liquidity needs, as alternatives are by definition less liquid than public market investments; alternatives investors trade liquidity for return potential. However, this market has been developing, and opening, to such a degree that it’s time to dispel the notion that you can allocate to alternatives only if you’re willing to lock up your capital for seven or more years. In fact, alternatives now offer a variety of time horizons. Some alternative investments (such as business development companies (BDCs), non-traded REITs and hedge funds) offer monthly and quarterly liquidity2. This liquidity profile often creates an ability to borrow, should that suit your needs. Indeed, you may be able to as much as get 35% to 50% lending value against such holdings.
  • Existing allocation to alternatives. Before setting a course for new investments, you’d also be wise to look at not only your current investments in alternatives but also at all the assets on your balance sheet. If, for example, you have a private business, you might want to count your investment in it as part of your allocation to alternatives (as your business is a private enterprise and your investment in it is likely to be not only locked-up for but also long-term.)
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3. Build a diversified alternatives portfolio.

We strongly recommend diversifying your alternatives portfolio itself and suggest doing so along key factors such as geographic exposure, manager selection and vintage year—as well as liquidity and strategy.

The need to diversify geographically is often obvious; across managers, sometimes less so. Yet, in any industry that has higher fees, less liquidity, and less transparency, you want to be careful. Exercise robust due diligence in choosing managers and make sure your manager roster is well-diversified.

As for vintage year diversification: Investors tend to over-over-allocate at the onset, because they want to ramp up. But one of the most important diversification strategies is to take a consistent, measured approach by allocating over multiple vintage years. You want to sustain your exposure and it’s difficult to know which future year is going to be provide the best opportunity.

For example, think about the outbreak of COVID-19. Imagine the chagrin of investors who’d only invested in vintage year 2017, so that all their capital was put to work by 2020 and they couldn’t take advantage of the COVID-19-generated dislocation but they did have a great deal of exposure to COVID-19’s outcome.

We believe the way to truly optimize your allocation is to allocate consistently. Our advice: Consider investing in no less than three vintage years. Many sophisticated investors strive to commit evenly over four to five years and to recycle capital thereafter.

Given the lifecycle of some alternative investments and how critical the timing of vintages is, we suggest that, if you want to get to, say, a 30% allocation to alternatives in your portfolio, you might consider investing only a portion, about 7% or 8% a year. You’d keep that pace until you get to your desired allocation—then refill the funnel as investments realize over time.

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4. Pick the right partner.

To pick the right partner, you need access to information about the managers running the investment as well as access to investment opportunities themselves.

The alternatives universe is vast (it now includes more than 18,000 private investment funds and 9,000-plus hedge funds alone).3 Evaluating and monitoring offerings is time consuming and complex, but critical as performance can vary widely. For example: on average, there has been a 21 percentage point difference between performance of top-quartile and bottom-quartile private equity managers and a 13 percentage point difference between top-quartile and bottom-quartile hedge fund managers.4