It may be, if you are a long-term investor committed to growth and take a strategic approach both to funding capital calls and maintaining target portfolio allocations.

We believe investors increasingly are interested in private equity.

Over the past 20 years, private equity investments in operating companies not publicly listed and traded on a stock exchange have outperformed traditional public equity markets. 

Source: Burgiss, FactSet; data as of September 30, 2017. The private equity asset class results are sourced from the Burgiss Manager.

 

Past performance is not an indication of future performance.

 

For illustrative purposes only.  The example does not reflect the performance of any specific vehicle and is based solely on the hypothetical illustration cited. Hypothetical examples are not intended to serve as a projection of any result.

A table comparing the private equity time-weighted performance (represented by Burgiss Private Equity Composite) against MSCI World and S&P 500.

For certain long-term investors, adding illiquid assets from the private markets to portfolios may help both enhance returns and provide the benefit of diversification.

If PE fits into your goals, then, the questions become: How much private equity might suit you? And how would you manage this type of investment in your portfolio?

First, of course, it’s important to understand private equity’s general characteristics.

Private equity demands patience. The potential for returns may potentially be high but that is because investors may be compensated for relatively long investment periods, illiquidity, and lower, even negative returns during early years.

Source: (Arithmetic) return and volatility based on 2018 J.P. Morgan Capital Market Assumptions. Strategic asset allocation of the model portfolios with hedge funds. Max total allocation to hold PE: Income/ Conservative = 20%, Balanced/ Growth = 30%.

 

Past performance is not an indication of future performance.

 

For illustrative purposes only.  The example does not reflect the performance of any specific vehicle and is based solely on the hypothetical illustration cited. Hypothetical examples are not intended to serve as a projection of any result.

A line chart showing the risk-return changes against income-, conservative-, balanced, and growth-based portfolio.

Specifically, private equity typically offers:

  • A long-term horizon with unique cash flow patterns
    The total life of fund investments typically extends over a period of 10 to 12 years from capital commitment to final distributions (Exhibit 3). The distributions vary in timing and magnitude, and occur over the life of the investment.
  • Illiquidity
    Commitments are generally for the long term. Unlike many other alternative investments, PE investments typically do not have reinvestment or redemption features.
  • J-curve effect
    The J-curve represents the pattern of potential returns an investor can expect to realize from a private equity fund over time, from inception to termination. Funds often have a negative return in their early years, when fees and start-up costs are incurred. Potential investment gains usually come in later years—as portfolio companies may mature, increase in value and are ultimately exited with returns realized.
  • Attractive return potential
    Investors who are able to make such long-term commitments to relatively illiquid private equity investments have the potential to experience rewarding returns over time.

Source: J.P. Morgan Asset Management, Private Equity Group.

 

Past performance is not an indication of future performance.

 

For illustrative purposes only.  The example does not reflect the performance of any specific vehicle and is based solely on the hypothetical illustration cited. Hypothetical examples are not intended to serve as a projection of any result.

A bar chart showing the typical annual cash flows of a single private equity fund.

Given that a single private equity fund may make capital calls during the early years and not begin distributions until the mid-to-later years, a strategy for most certain investors is to make commitments across several funds each year. That way, calls and potential returns are staggered.  

In addition, there are some ways to fund the capital call requirements:

  1. Reinvest returns from cash deposits.  You can set aside cash to fund capital calls over a fund’s investment period.
  2. Use cash flow generated from a fixed income portfolio to fund private equity capital calls. Fixed income has predictable income streams and lower volatility, providing a suitable barbell to manage capital call needs. Bond coupons can contribute to more cash available for capital calls compared to cash deposits. By projecting cash flow needs, we can work to work out a solution for bond maturities within the portfolio cater to cash flow gaps.

Let’s look how one investor, Investor X, might fund using a “fixed income barbell” approach (#2 above). And let’s say her:  

  • Initial overall portfolio market value = US$30 million
  • The percentage of portfolio she’s allocated to growth = 60%
  • The percentage of private equity in her “grow” bucket = 25%
  • Her target private equity portfolio allocation = 15%

By our calculations, Investor X would need a starting fixed income portfolio of just US $5 million plus an annual commitment of US $1 million.

Source: J.P. Morgan Private Bank, as of August 30, 2019

 

Past performance is not an indication of future performance.

 

For illustrative purposes only.  The example does not reflect the performance of any specific vehicle and is based solely on the hypothetical illustration cited. Hypothetical examples are not intended to serve as a projection of any result.

A chart showing the variation of private equity as a percentage of portfolio with annual commitment of US$1 million. Portfolio size is represented by blue bar and the PE as percentage of portfolio is represented by the orange line.

 

From a return perspective, Investor X’s expected annualized portfolio return over the next 10 years would be 7.3% p.a.1

Source: J.P. Morgan Private Bank, as of August 30, 2019.

 

For illustrative purposes only.  The example does not reflect the performance of any specific vehicle and is based solely on the hypothetical illustration cited. Hypothetical examples are not intended to serve as a projection of any result.

A chart showing the timeline of cumulative cash flow from 2019 to 2040. Expected income is represented in light blue bar, expected net private equity cash flow needs is represented by deep blue bar, cumulative cash flow is represented by orange line, net cash flow is represented by light green dots.

 

Leverage, when used to boost returns, can make portfolios more efficient. Assuming 50% leverage, the expected portfolio annualized returns over the following 10 years increases to 8.3% p.a.

How can investing in private equity help you reach your goals?

An illustration showing how investing in private equity can help reach the goals – in spend, divide, preserve and grow.

Within the “Grow” bucket, a certain proportion of your portfolio may be allocated to illiquid assets (private equity) to meet target returns.

Having a sufficient target allocation of private equity in your portfolio is essential to building a strategy that helps you achieve growth.

Work with your J.P. Morgan advisor to determine whether private equity investments suit your needs and, if so, how you might like to incorporate these opportunities in your portfolio.

Index definition:

Note: Indices are for illustrative purposes only, are not investment products, and may not be considered for direct investment. Indices are an inherently weak predictive or comparative tool.

All indices denominated in U.S. dollars unless noted otherwise.

The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The index consists of 23 developed market country indexes.

Standard and Poor’s 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index was developed with a base level of 10 for the 1941–43 base period.

 1Assumptions for scenario:

  • Yield on bond portfolio: 3.80%
  • Assumes that initial USD 30 million portfolio grows at an annualized rate of 4.5%
  • Funds call for capital evenly (straight line) across the investment period. No distributions are made during the investment period.
  • Funds distribute evenly (straight line) over the remaining term of the fund post investment period.
  • Any excess cash flow need is funded by bond portfolio maturities.
  • Any positive net cash flow is reinvested into the bond portfolio.
  • On the levered portfolio, assume average all-in borrowing cost of 2.15% and loan exists to perpetuity.

Other General Assumptions:
Multiple on Invested Capital:            1.80x
Current portfolio market value         30,000,000
Additional commitment each year   1,000,000
Investment Period                             5
Fund Term                                          10
Implied Fund IRR                               12.5%
 

KEY RISKS

Private investments are subject to special risks. Individuals must meet specific suitability standards before investing. This information does not constitute an offer to sell or a solicitation of an offer to buy. As a reminder, hedge funds (or funds of hedge funds), private equity funds, real estate funds often engage in leveraging and other speculative investment practices that may increase the risk of investment loss. These investments can be highly illiquid, and are not required to provide periodic pricing or valuation information to investors, and may involve complex tax structures and delays in distributing important tax information. These investments are not subject to the same regulatory requirements as mutual funds; and often charge high fees. Further, any number of conflicts of interest may exist in the context of the management and/or operation of any such fund. For complete information, please refer to the applicable offering memorandum. Securities are made available through J.P. Morgan Securities LLC, Member FINRA, and SIPC, and its broker-dealer affiliates.

While investments in private equity funds provide potential for attractive returns, access to opportunities not available in the public markets and diversification, they also present significant risks including illiquidity, long-term time horizons, loss of capital and significant execution and operating risks that are not typically present in public equity markets. Private equity funds typically have a 10-15 year term and will begin to monetize investments after holding them for 4-5 years.