The Importance of Diversification
Assuming that a family can gain access to top quartile private equity funds, either via funds of funds or directly, the next step is to diversify the PE exposure as broadly as possible. Note that there are many dimensions of diversification. We can diversify by:
- The type of investment (venture, buyouts, mezzanine, distressed).
- The stage of the investment (in venture, we can invest in early-stage, mid-stage, or late-stage investments).
- The industry (technology, healthcare, manufacturing, etc.)
- Geography (not just Silicon Valley or any other narrow geographical location that may be susceptible to simultaneous economic swoons, but nationally and even globally).
- Deal size (in buyouts, we can invest in large buyouts, small buyouts, middle-market buyouts, etc.)
- Vintage year. I mention this issue last, but in some ways it is the most important. PE returns are cyclical, and it is virtually impossible to anticipate those cycles. The only way an investor can ride out the bad vintage years is to be sure to be invested during the good vintage years. And the only way to do that is to invest consistently year after year.
The length of the time commitment to a PE fund can hardly be overstated. Consider that a PE fund of funds will typically invest over a four-year period of time. The underlying funds in which it invests will have lifetimes of 10 to 12 years, plus one or two one-year extensions. Adding it all up, we are already at a 15- or 16-year lifetime for the fund of funds, and 20 years is well in sight. Twenty years is pretty much the investment lifetime for a wealthy family investor!
My point is that PE funds, and especially PE funds of funds, must be chosen with extreme care. Our clients will be partners with these funds for many, many years.5