A Basic Framework For Private Equity Portfolio Construction

Objective

The private equity portfolio’s purpose is to leverage the illiquidity premium and the private market’s relative ine@iciency to generate returns that outperform the public markets, ideally by 5% annually over long-term time horizons. 

To achieve this goal, we seek to construct private equity portfolios that balance risk, return, and liquidity while maintaining consistent allocations within each client’s strategic asset allocation. This document aims to create a framework to guide the implementation and construction of such a portfolio.   

Key Principles

• Vintage year diversification: Private market returns are cyclical; rather than timing the market, we emphasize diversification across vintage years.
• Consistency: Building and maintaining a private portfolio requires consistent commitment pacing.
• Annual monitoring: Portfolio pacing plans should be reviewed annually to ensure alignment with long-term targets.
• Manager selection: Selecting top quartile managers is critical for the success of any private portfolio.
• Balance risk and liquidity: Make buyout the core of the portfolio due to its more attractive median returns, comparable top quartile returns, shorter duration, and lower volatility.

Pacing and Sizing

• Any private portfolio needs to manage prudent pacing and commitment sizing to achieve and maintain its target allocation within the overall portfolio’s strategic asset allocation. We use a private asset pacing model to project future cash flows and NAV appreciation, accounting for current portfolio maturity and strategic allocation targets. Each client’s situation and pacing will be unique, but for portfolios with 10-15% targets for private equity, a commitment pace of 1.5-2.5% of NAV is common.
• Given consulting model constraints, clients can make at most four commitments per year. We do, however, want to build well-rounded, diversified private portfolios. Therefore, our recommendation is for clients to make 3-4 commitments annually, ranging in size from 0.5%-1.00% of NAV, depending on expected fundraising cadence and manager conviction.

Strategies

The private equity portfolio will consist of commitments to illiquid strategies that typically have 10-12 year terms. We must consider the characteristics of available strategies to determine if they are a fit within our framework.

• Buyout strategies typically invest in cash flow positive businesses and often utilize leverage to facilitate the purchases. As control investors, buyout managers are actively engaged in their businesses and have greater influence over outcomes than managers of most other private strategies. Historically, buyout strategies have o@ered the best risk-adjusted returns in the private markets. According to Cambridge Associates’ benchmark data, the median buyout fund’s net IRR has never been negative and the median net IRR for mature vintages since 2000 is north of 15%^[1]. This compares favorably to venture capital where the median strategy has generated a net IRR of ~9% over the same period with ~50% more volatility. Buyout’s top quartile funds compare favorably to venture capital, generating better net IRRs and comparable net multiples. Due to these favorable risk and return dynamics, buyouts should serve as the core of any privates portfolio. We recommend targeting 40-60% of the private equity portfolio to buyout strategies.
• Venture capital is a strategy characterized by minority investments in startup businesses that are not yet near profitability. Due to their minority status and the dynamics of startup companies, venture managers are not as hands on as buyout managers. A defining characteristic of venture capital is the power law, whereby only a few investments end up driving most of the value for any venture capital portfolio. This concept applies to venture capital funds as well. We noted how the median fund and top quartile fund compares to buyout above; however, as we look deeper into the top quartile, venture capital funds start to outperform buyout dramatically from a net multiple perspective. Venture strategies in the top 5% since 2000 have generated net multiples of more than 5.0x, roughly two turns greater than buyout’s top 5%. Another defining characteristic of venture capital is its long duration. Given that venture-backed companies are inherently early in their life, the time to a liquidity event is longer than any other private asset class, making it the most illiquid private strategy. That said, due to its high return potential, venture capital plays an essential role in private portfolio construction. We commend a target of 20-30% to venture capital strategies.
• Growth equity is in between buyout and venture capital on the private equity spectrum. It often includes companies that are generating significant revenue and are growing at a fast rate. Managers in this space tend to be minority investors and as a result are not as engaged operationally as a buyout manager can be. There can be overlap with late-stage venture capital as well as with buyout strategies that occasionally take minority stakes. The risk/return/duration profile for growth equity

is between buyout and venture capital. The strategy is worthy of an allocation in private portfolios due to its attractive risk/return profile and due to the evolving capital needs of private companies. We recommend a 10-20% allocation to growth equity strategies.

• Secondaries strategies o@er the ability to buy interests in private funds and/or companies on the private secondary market, often at a discount. These strategies are characterized by shorter duration because the underlying companies tend to already be mature and closer to value realization. As a result, the multiple upside is muted, but the net IRR potential remains attractive due to the discount at purchase and the short duration. Secondary strategies are helpful to mitigate the j-curve of new private portfolios and can also serve as a cash flow diversifier that helps with liquidity management for mature portfolios. As a result, we recommend a 5-10% allocation to secondaries for more mature portfolios (and more to maturing portfolios, as we will discuss later).
• Private credit is a common private markets strategy that is often characterized by lending to private businesses. It tends to be a cash flowing strategy with shorter duration than other private strategies. The return profile for these strategies tend to be low-double digit IRRs at best, and thus might not be additive to our return target of public markets +5%. As a result, we believe the use of private credit is best addressed at the strategic asset allocation level, and that it only be included in private equity portfolios when the expected risk/return profile is additive to the overall portfolio’s return objective.
• Private real estate is a common private market strategy where the investments are underpinned by a real asset, whether it be a physical building or land. These investments are often cash flowing and investment is made by the manager with the goal of enhancing future cash flows. Given its real asset nature and expected returns, we believe, like private credit, that private real estate allocations should be addressed at the strategic asset allocation level. Inclusion in the private equity portion of the portfolio should be reserved for strategies with the potential to increase the risk/return profile of the portfolio.
• Private natural resources is a strategy that involves investing in real assets that are typically linked to commodities. These strategies often serve as inflation hedges and diversifiers within a portfolio. Although capable of generating outsized performance, due to their linkage to commodities and inflation, the expected return for these strategies do not typically reach our stated target. As with private credit and private real estate, we recommend that any decision to allocate to private natural resources be made at the strategic asset allocation level. 

Established vs Non-Established Managers

We believe our clients should take a core-satellite approach to private portfolio construction. We view core strategies as funds that are managed by established managers where the risk/return tradeo@ is viewed favorably and with greater confidence than it would be for a non-established manager. The confidence stems from the manager’s track record, our familiarity with the manager, the quality of its underlying portfolio, and/or the diversification they provide. 

Non-established managers tend to be managers on funds one to three, where the firm’s track record is still being established. Over time, non-established managers can move into the established/core category depending on Crewcial’s conviction level.

We view fund-of-funds as playing an important role in private equity portfolio construction. These funds are managed by highly skilled teams and that provide access to a diversified portfolio of highly curated funds. Despite the double layer of fees, select fund-of-funds o@er strong risk-adjusted returns and valuable diversification. We believe these fund-offunds can serve the role of an established manager and can be additive to the risk-return profile of any private portfolio. 

We recommend clients make 2-4 commitments to core managers over a rolling two-year basis. These commitments should be sized at the higher end of the commitment sizing ranges. We recommend 4-5 commitments to non-core strategies, sizing these on the lower end of the range.

Mature vs Building

A mature private portfolio is one where the actual allocation is at or above the target allocation and is self-funding. According to our modeling, for a portfolio starting from scratch, it can take 8-10 years to reach mature status. 

For portfolios that are building towards a target, we recommend increasing the number of commitments to j-curve mitigating strategies, such as secondaries. We also recommend limiting the number of commitments to longer duration strategies, such as venture capital. This will allow the portfolio to begin building towards a target allocation while not locking in long duration funds that are not expected to begin distributing meaningful capital until years 7-10. For Building portfolios, buyout remains a core strategy due to its moderate duration, strong returns, and more predictable cash flows. 

Mature portfolios can tilt their commitments towards longer duration strategies with higher expected returns. These portfolios should theoretically have more predictable cash flows and be self-funding. Exits can be lumpy and cyclical, particularly for venture capital funds, so we continue to recommend that mature portfolios include at least one secondary strategy every other year to help smooth out distributions.

Strategic vs Tactical

Our firmest conviction is that a successful private portfolio will maintain a steady, consistent commitment pace regardless of macro conditions. However, there will be periods of time where that will become challenging due to public market performance.

During periods where public markets fall, investors can experience the so-called denominator e@ect, whereby the total portfolio’s value falls and the private portfolio’s allocation increases as a result due to the timing lag inherent to the private markets valuations. During such periods, it will be challenging to continue committing when the actual allocation exceeds the target allocation. Likewise, when public markets are strong the actual allocation may be below the target allocation and investors may feel the need to increase the commitment pace. Deviations from consistent pacing can have long-term implications for the portfolio, such as being underweight attractive vintages or overweight frothy vintages.

To mitigate these issues, we recommend clients take several actions so that they can maintain a steady commitment pace:

• Put wide ranges around target private allocations. This can help investors to avoid the pull to overreact in either direction during dislocations.
• Utilize a rolling three-year NAV, net of cash flows, to calculate commitments. This will prevent portfolios from over-committing during hot markets and undercommitting during temporary down markets.
• Consider commitments over 18-month periods rather than 12 months. Dogmatic adherence to annual commitment schedules can lead to poor decision making and cause unnecessary anxiety. Private markets conditions do not rapidly change over any six-month period and thus pushing commitments back one quarter will not have a materially negative impact on the portfolio.

Managers and Strategies

Given our recommendations with respect to strategy types and number of commitments, we can now make assumptions as to what the portfolio will look like over the course of a 10-year period. Below is a table that lays out the number of commitments and manager relationships required to meet our goals:

Geographic Exposure

Geographic exposure within a private equity portfolio is best determined at the strategic asset allocation level. Should there be a market that we seek to obtain exposure to, there should be an assessment as to whether the market is best accessed via public or private investments, or some combination thereof.

As a default, we should expect that client portfolios will be heavily weighted towards North America due to proximity, abundance, and the track record of successful private investing in this market. Opportunities outside North America will be considered on a bottom-up basis in the absence of a strategic allocation mandate.

Sector Specialists vs Generalists

We are agnostic with respect to choosing sector specialists or generalists. There are certain sectors, such as health care, where specialization is beneficial and the market is large enough to where a specialized strategy can succeed. As the market opportunity narrows, there is a greater need to understand the opportunity in addition to the manager’s ability to execute. 

In general, venture capital tends to be weighted towards technology companies, which lends itself to a model that favors generalists due to the ever-evolving technological landscape. In some sectors, such as biotech, specialization is advantageous.

Summary

Constructing a private equity portfolio can seem overwhelming due to the volume of options, frequent commitments, and numerous line items. A structured approach, as outlined above, simplifies this process for investors. This framework, combined with strong manager selection, facilitates the construction of resilient portfolios that generate meaningful alpha, thereby supporting institutional missions.

[1] All referenced performance data is from Cambridge Associates