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Evaluating the Impact of Private Equity in a 60/40 Portfolio
Private Equity

Evaluating the Impact of Private Equity in a 60/40 Portfolio

By and June 25, 2020No Comments
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Introducing a private equity allocation to a traditional portfolio of publicly traded equity and fixed income securities may enhance returns and reduce risk.
Prior to the pandemic, many wealth advisors had already grown concerned about public market valuations and were exploring the private capital markets in the hopes of addressing lower return projections for their traditional 60/40 portfolios. Now grappling with market turmoil, these advisors are focusing on constructing more durable portfolios that can deliver positive long-term outcomes while also trying to prudently take advantage of the current dislocation. The past few months have provided a stark reminder that a lack of true portfolio diversification can expose investors to dramatic increases in volatility, significant drawdowns, and the potential risk of permanent capital loss.

As advisors seek to diversify client portfolios and assess which alternative strategies are best positioned today, many are also asking how to quantify the potential impact of a private equity allocation on the return and risk characteristics of a traditionally constructed portfolio. These advisors are genuinely interested in making the private capital markets a core component of their portfolios, though little has been done to help them quantify the potential long-term implications. The purpose of this paper is to help advisors better understand the utility of private equity in a portfolio consisting exclusively of public securities.

Using realized and publicly available forecasted data, iCapital1 has evaluated multiple scenarios that include the addition of private equity (PE) into a traditional 60/40 stock-bond portfolio. Each scenario presumes a 20% PE weighting, but models different funding options for the allocation – drawing it entirely from public equities, entirely from fixed income, or proportionately from both.

We ran the analysis using both historical (Exhibit 1) and expected (Exhibit 2) returns, volatility, and correlation inputs, and the outputs are illustrative. The analysis is intended to assist an advisor in developing a baseline hypothesis for return expectations and risk assumptions when constructing portfolios with an allocation to private equity. The information presented does not represent any actual portfolio.

historical performance of traditional portfolio and portfolio with private equityOver the 25-year period, a traditional 60/40 portfolio delivered an annualized return of roughly 8.5%, with a volatility2 of 9.4%. Compare that risk/return profile to each of the three portfolios that include an allocation to private equity. In each scenario – regardless of whether the capital is sourced from stocks, bonds, or proportionately from each – the portfolio return increases between 210 and 260 basis points (bps), with the higher returns earned when the PE allocation is taken entirely from the lowest return generator, fixed income. Not surprisingly, the volatility increases when the PE allocation is funded 100% from fixed income, decreases when funded 100% from public equities, and is slightly higher when funded pro rata.

DEVELOPING FORWARD-LOOKING ASSUMPTIONS

When constructing client portfolios and investigating new products, advisors must consider many variables and
their probabilities. In developing assumptions (Exhibit 2) for our forward-looking analysis, we reviewed long-term capital market assumptions (CMAs) from six firms, including global private banks, asset managers, and consultants.3 The average annual private equity return expectation across these firms is just over 9%, while the average public equity return assumption is roughly 6%. This anticipated spread in performance between public and private equity is generally consistent with the historical spread.

capital markets assumptions private equityDetermining a suitable expectation for the volatility of private equity was somewhat more challenging. For example, simply taking the realized volatility of an index of private equity funds may result in a volatility expectation is artificially low, since the quarterly reporting of PE performance effectively “smooths” the long-term results. This method would result in an index-based volatility in the 8%-10% range.

Conversely, some firms don’t use actual private equity data at all, instead attempting to replicate PE returns by using a public equity benchmark such as a small cap index and applying a leverage factor to determine a level of volatility. This approach results in a forecasted volatility in the range of 25%-30%, approximately three times the realized index volatility.

After examining numerous methodologies, we adopted the approach used by Hamilton Lane,4 which incorporates what we believe to be a sound, balanced methodology that uses actual PE data and statistically adjusts the realized returns to account for the smoothing effect. The Hamilton Lane model’s statistical output over multiple time periods results in an expected volatility of 16.1%, which is generally comparable with both realized and forecasted volatility for public equities.

HYPOTHETICAL FORWARD-LOOKING ANALYSIS

Measuring a portfolio’s “probability of success”

Using the model assumptions below, our forward-looking analysis seeks to demonstrate the potential impact of private equity on a traditional 60/40 portfolio through a tool familiar to many advisors. Envestnet’s MoneyGuidePro® models how a new investment product can impact the likelihood that a client will achieve his/her goals by comparing the probability of success of different asset allocations, given explicit client characteristics and goals, along with investment risk and return assumptions. After gathering feedback from CIOs at several wealth advisory firms, we developed a client archetype that represents a Qualified Purchaser client (Exhibit 3).

hypothetical qualified purchaser clientThe results of this analysis are described below and in Exhibit 4. Given the return and volatility assumptions referenced above, the probability that this couple will achieve their goal with a traditional 60/40 portfolio structure is 67%. In an uncertain world, those aren’t terrible odds, and some advisors might consider a “stay-the-course” approach to be most prudent.

However, with the addition of a 20% allocation to private equity, the probability of long-term success increases to 74%, 78%, and 81%, depending on whether the capital is sourced from fixed income, a pro rata blend, or from public equities, respectively. Of course, it is important to note that private equity is an illiquid asset class and, even if these return expectations are met, an investor’s private capital may not be available when needed. This simply underscores the importance of investing in private equity only after considering, in addition to return objectives and risk tolerance, the possibility of an unanticipated need for liquidity.

This analysis – based on a Monte Carlo simulation using the MoneyGuidePro software – projects the probability of a client achieving his or her long-term portfolio objectives. The output is meant to level-set expectations, based on a variety of client-specific and market-driven inputs. While these probabilities reflect a singular threshold percentile (e.g., an “X” percent chance of leaving “Y” dollars to a client’s heirs), the 1,000 underlying simulations provide a wide range of potential outcomes. For example, based on each asset allocation:

I. Existing 60/40 Stock & Bond Portfolio (Traditional)
The traditional 60/40 portfolio has a 67% chance of success. While there is a 33% chance of a client failing to reach his or
her long-term objective, on the upside there is a 50% chance (the 50th percentile) of leaving at least a $4.0 million bequest.

II. 20% to Private Equity – Funded from Fixed Income (Aggressive)
When the PE allocation is funded from fixed income, the portfolio has a 74% chance of success, while the probability of a “negative outcome” (the client fails to meet his or her goals) falls to 26%, with a 50% chance of leaving at least $7.5 million.

III. 20% to Private Equity – Funded on a Pro Rata Basis (Moderate)
The chance of success improves to 78% for the pro rata option. The negative outcome risk falls further, to 22% when the capital is funded equally from stocks and bonds, with a 50% chance of leaving at least $7.5 million.

IV. 20% to Private Equity – Funded from Public Equity (Conservative)
If the PE allocation is funded from public equities, the negative outcome is just 19% (reflecting an 81% probability of success), also with a 50% chance of bequeathing at least $7.5 million.

hypothetical likelihood of success of portfolios with private equityWEALTH SIMULATION

Evaluating a range of outcomes

In addition to forecasting the probability of success of portfolios with and without private equity, it can also be helpful to consider a range of “good and bad” outcomes for different allocations, recognizing that investment results can be highly variable. To account for the various scenarios that may occur over time, which can dramatically impact a portfolio, we collaborated with BlackRock’s Portfolio Solutions Team to run a 25-year wealth simulation on a hypothetical $1,000,000 portfolio. This simulation compares the various outcomes for a traditional 60/40 allocation and one that includes a 20% allocation to private equity, sourced pro rata from stocks and bonds. The analysis assumes that, after the first 10 years, 6% of the total portfolio’s value is withdrawn annually to accommodate the client’s spending needs.

This simulation suggests that adding private equity could boost long-term wealth creation, while simultaneously minimizing the potential for capital loss. For example, the median 50th percentile outcome forecasts that the value of the portfolio with private equity could rise by 78.8% after 25 years versus 38.7% for the traditional 60/40 portfolio. At each percentile level shown below, the portfolio with private equity is likely to come out ahead of the traditional asset-only portfolio (Exhibit 5).

Private equity has added significant value to institutional investors’ portfolios over the past quarter century. While PE returns may decline over the coming decade on an absolute basis, the performance spread over public markets is widely expected to continue. This is consistent with the inherent benefits of private equity: private equity firms can pursue longer-term investment strategies, private company valuations are generally less expensive than public company valuations, and there is more organic growth in the private markets. In addition, the illiquidity of private equity investments suggests a corresponding premium over more liquid public investments. As a result, adding an allocation to private equity may better position investors to achieve their long-term financial goals.

DOWNLOAD THE PDF: Evaluating the Impact of Private Equity in a 60/40 Portfolio

wealth simulation results

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1) Institutional Capital Network, Inc. and affiliates (“iCapital” or “we” herein).
2) Volatility reflects the standard deviation of returns for each representative portfolio. Source: Evestment.
3) We evaluated the most recent publicly available CMAs from UBS, Callan, Invesco, JP Morgan, Blackrock and BNY Mellon as of March 2020.
4) Hamilton Lane has been advising institutional investors on the private markets for almost 30 years and today has over $415 billion in advisory assets and $65 billion in discretionary assets.

WEALTH SIMULATION DISCLOSURES
The wealth simulation was created with MPI Stylus Pro with data provided by Morningstar. Aladdin Portfolio Risk Analysis: Charts and graphs provided herein are for illustrative purposes only. Neither BlackRock nor the Aladdin portfolio risk model can predict a portfolio's risk of loss due to, among other things, changing market conditions or other unanticipated circumstances. The Aladdin portfolio risk model is based purely on assumptions using available data and any of its predictions are subject to change. The Aladdin portfolio risk model is subject to significant limitations. This model is not intended to provide, and should not be relied upon for investment, accounting, legal or tax advice, or used with any third-parties. Equity and fixed income characteristics and allocations are for informational purposes only. Such characteristics and allocations are not intended to be predictions or projections of any portfolio's performance. Diversification does not assure a profit nor does it protect against loss of principal. The allocation of a portfolio may differ from the illustrations herein and there is no guarantee that the same level of diversification will be achieved. Each portfolio's allocation and targets depend on a variety of factors, including prevailing market conditions and investment availability. There is no guarantee that the allocations of the alternate portfolio show herein will be achieved. ©2020 BlackRock. All rights reserved.

IMPORTANT INFORMATION
This material is provided for informational purposes only and is not intended as, and may not be relied on in any manner as legal, tax or investment advice, a recommendation, or as an offer to sell, a solicitation of an offer to purchase or a recommendation of any interest in any fund or security offered by Institutional Capital Network, Inc. or its affiliates (together “iCapital Network”). Past performance is not indicative of future results. Alternative investments are complex, speculative investment vehicles and are not suitable for all investors. An investment in an alternative investment entails a high degree of risk and no assurance can be given that any alternative investment fund’s investment objectives will be achieved or that investors will receive a return of their capital. Private equity is an illiquid asset class, and even if return expectations turn out to be correct, an investor’s assets may not be available when needed. The information contained herein is subject to change and is also incomplete. This industry information and its importance is an opinion only and should not be relied upon as the only important information available. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed, and iCapital Network assumes no liability for the information provided.

With regard to backtested performance the backtested performance was derived from the retroactive application of a model with the benefit of hindsight and the strategies were not applied via a trading strategy to an actual portfolio during the periods described. Some of the trading strategies applied may not have been available during the time period. The backtested period contributed to the performance of the hypothetical blended portfolio. Similarly, models of
possible future outcomes depend on return and other expectations that may never come to pass, such as that future returns will be similar to past returns, that investments of the type historically available will continue to be available, and that economic, legal and other conditions will remain within historical norms. The performance shown does not reflect the deduction of advisory fees, brokerage or other commissions, mutual fund exchange fees, and other expenses an actual client would have paid. This presentation contains forward looking statements. Forward looking statements include, but are not limited to assumptions, estimates, projections, opinions, models and hypothetical performance analysis. Forward looking statements involve significant elements of subjective judgments and analyses and changes thereto and/or consideration of different or additional factors could have a material impact on the results indicated. Due to various risks
and uncertainties, actual results may vary materially from the results contained herein. No representation or warranty is made by iCapital as to the reasonableness or completeness of such forward looking statements or to any other financial information contained herein.

This material is confidential and the property of iCapital Network, and may not be shared with any party other than the intended recipient or his or her professional advisors. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of iCapital Network. Products offered by iCapital Network are typically private placements that are sold only to qualified clients of iCapital Network through transactions that are exempt from registration under the Securities Act of 1933 pursuant to Rule 506(b) of
Regulation D promulgated thereunder (“Private Placements”). An investment in any product issued pursuant to a Private Placement, such as the funds described, entails a high degree of risk and no assurance can be given that any alternative investment fund’s investment objectives will be achieved or that investors will receive a return of their capital. Further, such investments are not subject to the same levels of regulatory scrutiny as publicly listed investments, and as a result, investors may have access to significantly less information than they can access with respect to publicly listed investments. Prospective investors should also note that investments in the products described involve long lock-ups and do not provide investors with liquidity.

Securities may be offered through iCapital Securities, LLC, a registered broker-dealer, member of FINRA and SIPC and subsidiary of Institutional Capital Network, Inc. (d/b/a iCapital Network). These registrations and memberships in no way imply that the SEC, FINRA or SIPC have endorsed the entities, products or services discussed herein. iCapital and iCapital Network are registered trademarks of Institutional Capital Network, Inc. Additional information is available upon request.

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Joseph Burns

Joseph Burns

Joseph is a Managing Director, Co-Head of Research and Head of Hedge Fund Solutions at iCapital. Before joining iCapital, Joseph was Chief Operating Officer at TCS Capital Management, a global equity hedge fund where he focused on global business development and portfolio risk management. Joseph holds a BA in Political Science from Manhattanville College and an MBA from Fordham University. See Full Bio.

Nick Veronis

Nick Veronis

Nick is Co-Founder and one of the Managing Partners of iCapital, where he is Head of Fund Management. He is also a member of the company's Operating Committee. Nick spent 11 years at Veronis Suhler Stevenson (VSS), a middle market private equity firm where he was a Managing Director responsible for originating and structuring investment opportunities. He holds a BA in economics from Trinity College and FINRA Series 7, 79, and 63 licenses. See Full Bio.