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Philosophy
Alignment Capital Group believes that alternative investments can add value to a portfolio of traditional asset classes through increased returns and diversification of risk. ACG believes that private equity, in particular, has provided and will continue to provide superior risk-adjusted returns compared to traditional asset classes, such as stocks and bonds, for four primary reasons:
- Market inefficiency. Even after the adoption and implementation of the mark-to-market principles of FAS-157, the private equity market is less efficiently priced than the public equity market. This inefficiency allows managers with better information to capitalize on pricing discrepancies in the market, which can lead to higher overall returns than in more efficiently priced asset classes.
- Effective diversification. Private equity funds usually invest in a number of portfolio companies, typically from 5 to 25. The number of underlying positions in a fund is analogous to the number of stocks in a well-diversified public equity portfolio. Institutional private equity portfolios often consist of large numbers of such funds, which provides diversification and lowers expected risk. Also, the investment cycles of the sub-styles of venture capital, buyouts of various types, mezzanine debt and distressed securities tend to be either independent of or counter-cyclical to one another. Taken together, the diversifying effects of counter-cyclical sub-asset classes, each composed of portfolios of funds made up of portfolios of companies, dramatically reduce the risk inherent in a single private equity transaction and increase the information ratio (return per degree of risk) of both private equity as an
asset class and of overall portfolios containing an allocation to private equity.
- Size. In the public markets, research suggests—for a number of reasons, including a lower average amount of analyst coverage and the inherent ability to grow faster from a lower base—that smaller companies have tended to outperform larger ones over long periods. Research has also strongly suggested that, over time, the value approach (buy low, sell high) yields higher returns than the growth approach (buy high, sell higher). Companies in private equity portfolios are typically smaller and acquired at lower EBITDA multiples than the average public company, and this small-company value-based investment style may provide uplift to expected returns.
- Control. The typical private equity fund manager is highly involved in building portfolio companies into successful enterprises. Such managers rely on years of experience to increase value by making financial and operational enhancements to their portfolio companies. Compared to public stock portfolios, private equity portfolios therefore contain a large proportion of active return and risk (as opposed to the passive return and risk associated with public market indexes). This is beneficial because
- superior manager skill is rewarded by greater excess returns compared to the public markets and
- active risk tends to be independent of market risk and therefore acts as a diversifier within the portfolio.
On Portfolio Management
Portfolio management has historically been less a focus for institutional investors in private equity
than has manager selection. Although selecting outstanding investment managers is crucial to the success
of a private equity program, Alignment Capital Group has learned, through practical experience and
original research, that portfolio management is a primary determinant of the long-term performance of
a private equity portfolio.
Consequently, ACG believes that several aspects of portfolio management require close attention in the private equity program:
- asset allocation
- commitment policy and pacing
- sub-asset class diversification
- temporal diversification
- benchmarking
In particular, the nature of private equity partnerships requires that the investor carefully address pre-investment and re-investment risk by regular forecasting and management of portfolio cash flows.
On the Value of Experience
The firm believes very strongly that there is no substitute for prior experience when choosing investment managers. Alignment Capital Group’s empirical research suggests that there is a learning curve associated with investing in the private markets—good managers tend to improve performance over time.
Consequently, ACG places a premium on managers’ track records in the firm’s due diligence process. The firm’s research indicates that managers that have performed well in the past are significantly more likely to perform well in the future than those who have not.
On Diversification
ACG believes, based on empirical analysis and research, that large institutional investors in private equity may benefit from dedicated exposure to large buyouts, small- and mid-market buyouts, venture capital, distressed securities, mezzanine and to new and emerging funds of all types. Each of these sub-asset classes is desirable in its own right but in combination they are less risky (the investment outcome is less variable) than a portfolio composed of only one of them. An additional, and frequently overlooked, aspect of diversification is the need to invest across vintages—so-called temporal diversification. Used together, sub-asset class diversification and temporal diversification can make it possible to assemble a portfolio of private equity funds that equals or exceeds the investment efficiency of the major public market indexes.
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