Much of the investment literature focuses on diversified portfolios, such as stocks and bonds. However, the correct calibration of peripheral components, i.e., cash in the one hand and private capital in the other, can greatly help to develop a portfolio in line with investment objectives. The latter aspect is now becoming more relevant in a world where the need for diversification and the pursuit of benefits become increasingly crucial. Randall Castillo Ortega, the founder of RACO Investment, discusses why investments private equity funds are a sensible alternative for diversification.

There are primarily four reasons to invest in private capital in the long run. The first is to add value to passive investments. Explains Castillo, “Major private equity managers have the possibility of adding considerable value to passive investments in public markets. The cumulative annual return of the last ten years for the top quartile exceeds 17% for private capital in the United States, and almost 14% for Europe. In this context, this data is compared favorably with returns of 11% and 4%, respectively, in the case of equity funds in those markets.”

Diversification in the investment portfolio is also a potential benefit. Investments in private equity funds add diversification to an investment portfolio, so they can improve their risk/return profile. Private capital provides access to investments and market segments that are impossible to reach through public markets. It also allows you to access versions of strategies with less liquidity that we have already invested in. Therefore, private equity allows investors to diversify risks and improve the efficient border of their portfolios.

The number of companies listed in private equity funds is increasing; consequently, an investor-oriented exclusively to public markets will be left out of an increasingly important part of the total number of opportunities. Asserts Castillo, “The universe of companies listed in public markets is shrinking, a trend that has intensified since the turn of the millennium. In other words, public markets are transforming from acting as a cash collection mechanism to a cash-back mechanism. In contrast, in private assets there are opposing trends: due to new regulations and tightening of the requirements imposed on listed companies, more and more companies choose to leave public markets and enter private capital, or directly prefer to stay in private hands indefinitely.”

Investments in private equity funds force investors to take a long-term perspective, thus avoiding tactical and behavioral errors. Approaching private equity funds can be very advantageous in the long run, as various empirical studies show that private investors, in particular, tend to get a lower return compared to a long-term strategy based on buying and maintaining. There are several reasons for this, and the first is the excessive frequency of your transactions. The second is to recalibrate your wallet too often; finally, they make mistakes when trying to synchronize with the market.

The wide dispersion of profitability in private capital makes the choice of manager a fundamental factor. It is necessary to cover the entire spectrum without limitations, in order to identify and access the most efficient managers. Access to top funds has become a major challenge and requires the backing of a strong institutional franchise.

Private capital is a long-term asset class and therefore requires a long-term investment horizon. To avoid the risk of synchronizing with the market, an investor must make constant assignments to this asset class over time. Similarly, you should set your individual asset distribution taking into account your profitability targets, time horizon, and expected liquidity needs.

Thirdly and lastly, it is important to take care of the proper design of the portfolio. There is no “correct” allocation to private capital as an asset class, as distribution depends on each investor’s risk tolerance, investment objectives and liquidity constraints. In order to determine the appropriate distribution, an investor must carefully assess its individual “balance sheet” (assets and liabilities), as well as its future cash needs. “Proper portfolio design also means ensuring the ideal diversification between sectors, managers, geographic areas and strategies,” concludes Castillo. “This dynamic requires targeting core assignments to managers who have generated attractive profitability in different cycles and, in parallel, making tactical assignments to featured managers as conditions change.”