The Case for Continuous Investing
Recently, we spent some time with an institutional investor whose private equity allocation was under review. Some of the decision makers wanted to increase it and some wanted to reduce it. Our advice was to be patient, look for managers that have delivered consistent returns of 500 bps above the long-term stock market returns, and to invest every year. If this formula is followed, private equity can play a reliable and positive role in any investment portfolio. If the net returns are reasonably consistent, then the private equity component of your portfolio should become self-funding. The important discipline in traditional close-ended private equity funds is to invest the same amount every year. Then, your portfolio will eventually have companies that are being sold while others that are being acquired. In that way, the risk associated with getting the timing right with respect to economics swings is substantially reduced.
We established our Kensington Private Equity Fund as a permanent pool of capital with the theory being that investors would enjoy periodic distributions of realized capital gains and be able to increase or reduce the principal at work at regular intervals. Within the Fund, there are companies that was acquired in 2002 and others just this year. We have been investing through the expansion leading up to 2007 when confidence was running high. We were still investing in 2008, 2009, and 2010, when uncertainty prevailed, and prices were very soft. We continue to invest throughout the expansion that ensued and continues.
Importantly, throughout the entire period, we have sold companies in the portfolio. Some at very strong prices, but when the prices have not been attractive, the companies have not been sold, and the managers redoubled efforts to grow them. Similarly, in buoyant times there is no pressure to buy. We can be patient because the fund is an evergreen fund. We distribute realized capital gains and re-invest the principal. Investors are open to add or reduce the capital they have invested.
The reason the Fund is not correlated to the public markets is partly because the investments are private and therefore not subject to the volatility of the public markets, but they are subject to economic cycles. The ups and downs of the economy are dampened by the diverse age of the investments.
There is much more to successful private equity investing than patience, but it does help! A tremendous amount of work goes into developing and executing a business plan that creates equity value in a company. Ensuring the management team is right for the task at hand is probably the most important task of any owner, including private equity investors meaning both private equity fund managers, and those of us who invest in private equity funds. Knowing the business intimately, it’s competitors, and its customers, allows smart owners and managers to identify and capitalize on opportunities as they arise. Being properly capitalized with enough financial flexibility to build the business, withstand bad surprises and invest in good ones is an art. It takes a lot of analytical work, strong relationships with other capital providers, and most importantly, an extremely good understanding of the business. Business understanding is critical. When the private equity investor and the company management team are working hand-in-glove then some real value can be created by the application of their combined skills.
We sympathize with the investor’s quandary of whether to increase or decrease the private equity component of the portfolio. Theories abound about the best way to design and optimize a portfolio. We think in more basic terms:
1. Equities are intended to be a way to grow capital;
2. Some equities are public, and some are private. Public equities are dwarfed by the volume of private equities, most companies are private;
3. It stands to reason that an equity portfolio should include both;
4. Investors are limited to buying both when they have capital available, and when investment opportunities are open;
5. Without the benefit of a perfect economic forecast, investors might consider dollar cost averaging as a means of managing the timing risk. It’s a tactic often used by long term public market investors;
6. Look for consistent returns that meet your portfolio needs. Don’t swing for the fences, and don’t chase one-time wonders. Invest in quality management;
7. Find a method or an investment vehicle that encourages this type of investing.
Continuous investing allows investors to assess the progress they are making as results starts to roll into the portfolio. Adjustments are easy if they are small in scale and spread over time, and continuous investing should deliver the returns that reward patience!