Diversifying portfolios with private equity

This article is intended for readers with a good understanding of investments. Investing in private markets is often complex and illiquid and brings higher idiosyncratic risks than investing in public markets, and as such, it is suitable only for experienced investors. This article is also general in nature and provided for informational/educational purposes only. It does not take into account any specific investment objectives, the financial situation or particular needs of any particular person.

Key points

• Stock markets have seen almost unprecedented returns in the last two calendar years. But it looks like tougher times may be ahead.
• Could investing in private markets be an answer? It offers scope to create more diverse portfolios.
• Indeed, many companies in promising industries are remaining private, rather than going public, for longer. 
• Building a portfolio of private equity holdings from different launch years, or vintages, is one way to target better risk-adjusted performance.

Public stock markets have produced very strong, almost unprecedented, returns in the last two years. Whether this can continue remains to be seen. However, in the face of trade tensions and fewer rate cuts than previously expected, performance could moderate this year, as explained in 2025: Time to deliver. 

Given the tough outlook for the next few months, are prospects for private markets any better? If nothing else, it may be time for investors to consider fresh ways of diversifying their portfolio. 

Consider going private 

As outlined in Is private equity still relevant for investors?, private equity (PE) investments offer an illiquidity premium that can help investors to improve risk-adjusted returns. In addition, PE’s lower correlation to traditional asset classes can make it a good diversifier.  

Investing in PE alongside a traditional, well-diversified portfolio can shift an investor up the so-called efficient frontier, implying a better trade-off between risk and return. 

In addition, PE widens the pool of portfolio investments. Indeed, many funds invest in early-stage companies with high growth potential, such as those in artificial intelligence or fintech. Many of these companies are remaining private for longer, drawing from the ever-deeper pool of private equity and debt markets to raise capital. This trend is an important consideration for investors looking to access emerging themes and technologies. 

Deal market reawakens 

Steep interest-rate hikes have proved challenging for PE funds in recent years. As such, elevated borrowing costs and smaller valuation multiples were seen, which ultimately supressed PE deal activity. The change in financial conditions also created an imbalance between today’s buyers and sellers, the latter having acquired assets when leverage was cheaper. 

Encouragingly, this is changing. Deal activity last year beat the levels seen in 2023¹. Lower interest rates and the looser financial regulation promised by President Trump might further stoke deal activity in 2025, offering a broader opportunity set to PE managers. 

Easier access  

The private equity market remains hard to access for most investors, not least as PE funds tend to have high minimum investment levels. In addition, due diligence is complicated.

Fortunately, the industry has tried to address these shortfalls. There are now funds which hold a diversified selection of PE investments. This offers investors exposure to a range of strategies wrapped up in a single investable instrument. But diversification is only half of the challenge.  

Riding the cycle

Just as in public markets, timing investments is difficult. This entry point, referred to as “the vintage” in the private equity world, or the year in which the PE fund starts investing, is an important driver of fund performance. 

Indeed, different vintages face the changing economic conditions of the time. As such, performance between funds with different vintage years can vary considerably. For example, the best vintage years often arise during times of market stress and dislocation. But these are the times when investors tend to shy away from risk taking. This is why investing through the cycle can be a valuable strategy. 

Build a cellar 

Just as a wine collector stores a selection of vintages and producers in their cellar, the astute investor might deploy capital across a range of PE vintages and strategies. Such diversification can unlock different sources of return and reduce overall portfolio volatility, by holding investments that were initiated at different stages of the economic cycle. 

Additionally, frequent allocation to new vintages can allow distributions from older funds to be recycled into the capital calls from younger funds. Skipping vintages can delay this, and create gaps in distributions.

Addressing risks

Public equity prices reflect new company information and the perception of risk as it happens. PE valuation works at a slower pace, without this mechanism of price discovery. While this helps from a volatility perspective, it highlights the importance of selecting the right fund manager, one that can identify opportunities with favourable risk/reward characteristics, and so structure investments in a way that reduces the variability in cash flows and distributions.  

Another consideration for investors is the need for liquidity. PE funds typically lock-up capital over several years – this illiquidity premium is why they can potentially offer a higher return than public markets over time. But, as a result, investors might be unable to exit their position, just when they need the funds.

Approaching PE investing 

Investing in private equity can help to create well-diversified portfolios capable of meeting an investor’s long-term goals. Once reserved for the savviest and wealthiest, the PE industry is becoming more readily accessible. 

It is crucial to remember that the same core investing principles apply, whether in public or private markets: it’s all about being and staying invested in a diversified fashion. Spreading capital across PE strategies and vintages can help to cut portfolio volatility, while reducing the risk of one key impediment to long-term performance: missing the best times to invest (or sell) in the market.