The Myth About Diversifying With Private Investments

Following the ‘07-’08 Financial Crisis, the financial markets saw a massive upswing in private market investments because of the desire by investors to move away from Wall Street volatility that saw many investors lose more than half the value of their portfolios during the crisis.

The myopia of investing in the public markets where investors who were only used to seeing it one way or used to doing what was comfortable, lost their retirement saving when the public markets imploded.

They had no other leg to stand on like those investors who had diversified away from public markets long ago in favor of private markets.

Investors who had already hedged against Wall Street volatility by allocating large chunks of their portfolios to private investment alternatives were able to ride out the storm much better than their public investing counterparts.

They fared better because they had long known that private investments offered the opportunity to achieve higher risk-adjusted long-term returns and greater diversification than available through the public securities markets.

Diversification in the public markets is typically more limited than diversification in the private markets.

In the public markets, diversification revolves around the “don’t put all your eggs in one basket” mantra. The idea is not to put all your capital into only one stock. This is risky since it’s not unusual for a single stock to go down 50% or more in one year, you could lose your shirt in a short period of time.

It is less common for a portfolio of 20 stocks to all lose 50% of their value in one year as risk is spread out through a multiple of companies.

Furthermore, if the stocks are selected from a variety of industries, company sizes, and asset types, it is even less likely for a 50% drop in portfolio value.

Elite investors have known about and taken advantage of the many ways to diversify with private investments for decades.

Private investment markets offer the opportunity to diversify in more ways than just owning stock in more than one company like in the public markets.

In the private sector, diversification can be accomplished across a variety of factors, including 1) alternative class, 2) stage of development, 3) security type, 4) type of return 5) holding period, and 6) geographic location.

Alternative Class & Sectors

Common alternative assets favored by elite investors include private equity/debt, venture capital, real estate, and commodities.

Private equity/debt and private equity can further be diversified by industry, including, for example, high tech, real assets, green tech, manufacturing, healthcare, oil & gas, medical, construction, and engineering.

Real estate offers diversification through a variety of asset classes, investment types, and geographic locations. The main real estate types include commercial, residential, farms, and infrastructure.

Residential real estate can include single-family, condos, garden homes, and vacation homes.

Commercial real estate can be divided into asset classes, building condition and location, and risk-reward profile.

The six primary CRE asset classes include multifamily, office, industrial, retail, hospitality, and development. CRE can be further classified by building conditions and locations designated with the letters A-D. Finally, CRE can be classified by risk-return profile with the designations Core, Core-Plus, Value Add, and Opportunistic.

Commodities can include energy (e.g., crude oil, natural gas, etc.); livestock (e.g., lean hogs, pork bellies, live cattle, and feeder cattle), agriculture (e.g., corn, soybeans, wheat, rice, cocoa, coffee, cannabis, etc.) and precious metals (e.g., gold, silver, etc.).

Stage of Development

Private markets offer investment in companies at various stages of development with varying risk-reward profiles. The five stages of business development (i.e., the business life cycle) include:

  • Development/Seed
  • Startup Stage
  • Growth/Survival
  • Expansion/Rapid Growth
  • Maturity

Companies ate the development/seed, and startup stages exhibit the highest risk but also offer the opportunity for the highest returns while companies on the maturity end of the spectrum exhibit the lowest risk but the lowest upside.

Security Type

The type of security offered through a private investment can vary by the entity structure and whether equity, debt, or a combination of both is being offered.

Common equity types can include common stock, preferred stock, membership interests, limited partnership interests, general partnership interests, options, and warrants. Debt securities can consist of promissory notes (including convertible promissory notes), bonds, and certificates.

Type of Return

Tied closely to the type of security being offered is the type of return. Debt securities typically provide a fixed return. Straight equity offerings usually provide the promise of appreciation. Preferred equity can often offer a waterfall compensation structure involving a combination of a preferred return akin to a fixed return, a percentage of profits from cash flow, and a percentage of profits from appreciation.

Holding Period

Unlike public investments, private investments are illiquid with typical holding periods of between 2-7 years. Depending on the private investment fund, early redemption may or may not be offered before the exit date; but in any case, usually only after a minimum holding period and possibly with a withdrawal penalty.

For example, an investment with an exit scheduled after the seventh year may offer early redemption after a minimum 5-year holding period and a penalty of 10% of the investor’s capital balance.

Geographic Location

Geographic diversity can be accomplished through investment across local, state, national, and international markets.

Elite investors have gravitated towards private investments for years. Private investments act not only as a shield from Wall Street and as a hedge against inflation but also are superior risk-adjusted returns. Compared to public investment options and the variety of ways, this investment offers diversification through a combination of asset classes, development stages, security types, types of return, holding periods, and geographic location.

Mike