Investing in private markets: How to build a portfolio
Published on 01.11.2023
For a long time, investing in private markets was a privilege reserved exclusively for professional and institutional investors. Now, private investors can also access the private market by investing through fund solutions. It’s a popular option - and for good reason: Over the past 20 years, private market investments have generally1 outperformed public stock indices like the S&P 5002. What’s more, their unique characteristics make them an appealing choice for diversification and for unlocking additional returns potential for a portfolio. One question that arises with fund solutions: How can a portfolio be tailored to the investor’s individual goals and requirements?
Three building blocks for a strong private market portfolio
Whether as a standalone investment, or as an addition to an existing portfolio, private market investments should always be aligned with an overarching investment strategy.
A private market allocation of around 10 percent is generally recommended for diversifying an existing portfolio. However, the precise weighting and composition will depend on various factors and should be based on the investor’s individual needs and goals.
The following “building blocks” can be considered for a private market portfolio:
Primaries are newly issued private market funds. The investor’s money is invested in new closed-end funds that invest directly in a selection of privately held companies. As with the stock market, these can be small-caps, mid-caps or large-caps3 that are focused on specific industries and sectors depending on the fund strategy. The investment horizon can span several years, and the invested capital is contractually committed during this term.
Secondary investments can be seen as second-hand primaries. Unlike primaries, they are not newly issued fund units but ones that have already been in circulation for some time. Thus, the seller is not the fund provider. Instead, they are an existing investor who is selling their units prematurely. With secondaries, the focus is on the potential for capital appreciation over the remaining term.
With co-investments, investors participate directly in the performance of individual companies on the private market. This type of investment is usually accessed through a fund provider, who is responsible for selecting the companies. In this scenario, the investors act as co-investors. Co-investment constitutes an almost-direct investment in individual companies, making it riskier than primaries and secondaries, but also offering the potential for higher returns.
What are the benefits of the different portfolio building blocks?
Private markets have seen significant growth in recent years, leading to an increase in newly launched funds as well as greater specialization of funds within the industry. This offers investors a wealth of opportunities to strategically diversify their portfolios. The fund units typically have a term of several years.
Due to the unique mechanics of primaries, their performance usually follows a J-curve trajectory: Since the allocation of invested capital tends to span several years, the initial return potential is low and often further eroded by the associated fees. However, as more of the allocated capital is put to work, the potential for returns increases and the impact of fees on the portfolio’s growth diminishes. For this reason, primaries don’t usually reach their full potential until the second half of their term.
The remaining holding period can be shortened by purchasing fund units that are already part-way into their term, allowing quicker access to potential returns. Since secondaries are typically bought at a discounted price, the buyer immediately benefits from an immediate unrealized gain as soon as the transaction is completed. Any residual risk and potentially limited growth prospects are factored into this discounted purchase price.
Secondaries can be used within a portfolio to balance out the slower investment activity that is often seen in primaries’ initial phase, for instance. As the seller usually wants to realize some of the accrued gains and the invested capital is already fully allocated, their growth potential is usually lower than with primaries.
Like publicly traded securities, co-investments in individual companies come with a higher risk, but they also offer the potential for higher returns. Thus, they are often viewed as potential investment multipliers. Since these investments are typically acquired as existing holdings, they usually have shorter terms than primaries. As with secondaries, the capital invested in co-investments is fully allocated, allowing potential returns to be realized more quickly. One difference compared to primaries is that no management or performance fees are usually incurred for co-investments, making them more cost-effective.
The right investment strategy for you
Investing in private markets often requires a high minimum investment. Creating a well-diversified portfolio can therefore demand substantial amounts of capital, which is then tied up for lengthy periods. On top of this, the different types of investments and the specific performance variables add a further layer of complexity to private market investments.
For private investors, it can therefore be worth considering an integrated solution with various portfolio components pre-selected, assembled and monitored by experts. On the one hand, this enables investors to benefit from bundling, which not only lowers the financial barrier to entry but also offers more flexibility with regard to the term of the investment. On the other hand, the investment can be structured as part of a broader investment strategy that takes into account the interplay between all building blocks and is aligned with the investor’s objectives.
If you would like to learn more about private market investments for your portfolio, please contact our experts for a no-obligation consultation.
Private markets: An introduction
1 Source: Private Equity & Venture Capital Index and Benchmark Statistics, Q4 2022, published by Cambridge Associates (CA).
2 Standard and Poor’s 500—US stock market index of the 500 largest publicly listed companies in the USA.
3 The terms “small-caps, mid-caps and large-caps” refer to the market capitalization of a company.