(June 7, 2012) — Institutional investors should aim to stray away from static commitments to private equity, according to a newly released academic paper.
For the most part, institutional investors allocate to private equity in predetermined commitments — an approach that is limiting, one of the paper’s author’s, Gerben de Zwart of APG Asset Management, tells aiCIO. Instead, investors should pursue a dynamic private equity recommitment strategy, the paper urges.
The paper — which has evolved from five years of research conducted by Zwart along with authors Brian Frieser of the ROBECO Group and Dick van Dijk from Erasmus University Rotterdam — notes that for each period, the ideal level of new commitment should be determined by characteristics of the existing private equity portfolio, including received distributions, uncalled capital from old commitments, and the current allocation relative to its target level.
According to the paper, institutional investors must deal with irrevocable commitments, cash flow uncertainty, and illiquidity when making new commitments to maintain their portfolio exposure to private equity funds. “This gradual year-on-year private equity allocation among investors is first and foremost a way to mitigate risk,” Zwart concludes. He continues: “The real risk for investors in private equity is the irrevocability of commitments along with the fear that you can’t sell investments.”
Looking ahead, Zwart notes that despite the barriers to private equity investing, namely its illiquid, more complex nature, investors will continue pursuing the asset class for improved diversification, with smaller funds likely having more to gain by being increasingly dynamic in their recommitments. “Private equity is a specialized investment. If you lack the expertise in the sector, investors very often end up with a static allocation,” Zwart says, noting that small and average-sized pensions with especially limited resources are often the investors guilty of a static recommitment approach.
“Small and average-sized pensions will often have small allocations to private equity and may benefit most from this paper,” Zwart concludes.
Advice to institutional investors large and small: Develop a dynamic recommitment strategy to preserve the strategic allocation to private equity.