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Institutional investors’ private equity

by Chao Chen

Institutional investors’ private equity


Asset allocation refers to the strategy of balancing risk and reward by adjusting portfolio holdings relative to risk tolerance and investment horizons. The concept first arose in the 1930s. The associated mean-variance analysis model proposed by US economist Harry Markovitz is a common analysis framework used by institutional investors. A preferred alternative to the mean-variance model is the endowment model of investing, which supports three assets: value-maintained or valued-added portfolio assets, macro hedge assets and diversified assets.

Under this methodology, the endowment model would first allocate a considerable portion of a portfolio to less liquid assets. Next, investors would increase allocation in hedge funds, which are less correlated to traditional stocks and bonds, and then move from domestic allocation to global asset allocation. The final focus would be on investment outsourcing.

Large institutional investors, including pension funds and sovereign funds, have low liquidity requirements and must work to a long-term investment horizon. Private equity investment, meanwhile, offers high potential returns on the one hand, and low asset liquidity, a long income cycle and high management costs on the other.

Private equity realignment
In the last five years, large institutional investors adapted their strategies to investing in private equity. First, holdings of private equity assets increased to offset the impact of low interest rates on returns. Second, they placed more emphasis on long-term investments and explored opportunities in differentiated investments. Third, more attention was paid to post-investment management and value creation.

The criteria for fund selection can be summarised under the ‘five-P’ guidelines: people, plan, performance, procedure and policy. There are significant strategic differences when investing in leveraged buy-out funds, venture capital funds and growth funds. The core principle of leveraged buy-out funds is to realise value creation. This means they look to invest in industry leading companies and in defensive markets.

Companies with high growth potential, excellent management and a wide range of exit possibilities are much sought after. Reasonable prices and controlling ownership in corporate governance are similarly attractive qualities. Private equity investment offers a lucrative alternative for large institutional investors searching for suitably long-term and illiquid assets. ▪

Chao Chen is Deputy Head of the Research Institute and PhD Research Fellow at China Investment Corporation.