Diversification is a common investment technique that is used to allocate capital across various types of investments in order to increase returns while decreasing overall risk. According to Mark Hauser, a private equity investor and fund manager, diversification can be achieved in several ways such as investing in an array of assets within an asset class or investing in international markets, but all are done so with the intention of mitigating risk.
One way to diversify a portfolio is by investing across asset classes. Traditionally, one of the most popular allocation strategies was to allocate 60 percent in public entities and the remaining 40 percent in bonds. However, the high inflation, increasing interest rates, and high uncertainty of recent years have destabilized this once consistent strategy. Today, Hauser says many investors have been moving away from such models and adding allocations to alternative asset classes such as private equity.
Private equity is an ownership or stake in an entity that is not publicly traded or listed. Private equity firms purchase and manage private businesses before releasing them for a profit. These firms create funds by collecting money from investors and investing in businesses on their behalf. In almost all cases, a private equity firm will either take a controlling stake or purchase the entire company outright. The businesses in a private equity fund are called their portfolio companies, and firm partners will work with their portfolio companies’ executives to improve the business and facilitate growth.
Mark Hauser said the relationship between private equity firms and their portfolio companies is unique in that they take an active role in ensuring their investment ends in a profitable exit. Meanwhile, the portfolio companies are able to achieve larger growth at a much more rapid pace than they would have been able to without a private equity firm.
Venture capital is often grouped with private equity, but they differ in that venture capital firms typically target startups, early-stage and emerging companies that have been deemed to have high growth potential, while private equity firms can have a broader scope and may decide to invest in a company that is failing or underperforming.
In recent years, institutional investors have begun diversifying towards alternative asset classes such as private equity. Since peaking in the 1990s, the number of companies publicly listed on United States exchanges has steadily decreased, and the rise of private market asset classes like private equity is assumed to be linked in part to the declining number of exchange-listed stocks.
Allocating portfolio space to private equity means that investors will hold a broader and more varied section of the investment landscape. Hauser points out that often companies with strong potential for performance have not yet entered public markets, and investing in them can spread risk at a lower level, preventing too high of a concentration and improving a portfolio’s overall diversification.
Private equity can be a valuable addition to a diversified investment portfolio. However, investors must understand that it comes with a degree of risk and requires thoughtful planning and due diligence. Allocating portfolio space to private equity can improve a portfolio’s overall diversification and reduce risk.
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