Any investment portfolio in present times should be complemented by a higher share of private equity, which will help it generate higher returns and beat current inflation and the foreseeable rise in interest rates in the process. Technology can play a very active role towards that objective.
In recent months we have experienced turbulence in the financial markets, where the valuations of virtually all listed liquid assets have fallen rapidly, mainly due to interest rate hikes, persisting doubts about global growth, lofty valuations of listed companies, and market volatility resulting from Russia’s invasion of Ukraine.
As a consequence of all these events and the lingering market volatility, many investors are scouting for opportunities in the listed markets in general and in the fixed income market in particular, where we have experienced a significant correction in prices, which, we believe, will continue.
Our view is that real growth in the economies is going to be limited, even as authorities institute measures such as interest rate hikes to try to control inflation (probably somewhat more in grip than what we are currently experiencing).
Although the increasing coupons on bonds make them appear more appealing now than they were a year ago, we see this as more of a mirage and therefore do not consider fixed income as an alternative in investment portfolios on a structural basis, since fixed-rate instruments (most fixed income instruments) will lose real value as interest rates rise and their real yields, therefore, fail to keep up with inflation.
Considering an average inflation rate of 3% over the next 10 years, a coupon of approximately 2% offered by the Spanish 10-year bond right now does not even provide a cushion against inflation. To this we must add that the rate hikes anticipated by the European Central Bank itself will lead to losses in the nominal value of the bond, and this will be even more accentuated for bonds of higher durations. Thus, in our view, the only thing that will be fixed in fixed income over the next few years is the probability of these instruments eroding the capital invested.
Given this scenario, it becomes pertinent to complement portfolios with private equity investments that are capable of generating high risk-adjusted returns. In more specialised markets, investment percentages as far as private equity is concerned are well above those usually observed in Spain, where these are below 10%. The Harvard University Endowment, for instance, has increased its exposure to private equity to 34% from 16% in recent years. This has been detailed in reports by the university itself and Bloomberg with respect to this academic institution’s permanent endowment.
Therefore, we strongly believe that an investment strategy oriented towards private equity is a necessity. Caution, indeed, is warranted, but we also see it as an opportunity amidst the prevailing uncertainty.
These statements and recommendations are in line with the September 2020 report by UBS (“Allocating to private equity in a multi-asset class portfolio“), which highlights that the most conservative investors seeking to preserve their wealth should have at least 5% exposure to private equity, rising to 10% in the case of balanced profiles, 15% in aggressive profiles, and 20% in the case of very aggressive profiles. These percentages, as we have seen, are notably higher than those recorded in Spain.
So, which private equity assets should we incorporate into portfolios? Our view is that technology is going to play a key role here, although this is not a recent phenomenon and has been happening over the last few centuries. The agricultural revolution, the development of oil, the development of the automotive sector, and even the development of the energy sector all had technology at the forefront. As the business landscape continues to evolve, technology will play a key role in the development of the business fabric in the coming years.
During the pandemic, we saw how e-commerce and artificial intelligence witnessed an exponential growth. Countries such as Germany and the European continent in general have promoted strategies to evolve towards Industry 4.0, the fourth technical-economic cycle that humanity has witnessed since the First Industrial Revolution more than two-and-a-half century ago in 1760.
This technological leap is also called Industry 4.0, a paradigm shift that was first defined in 2011 by the economist Klaus Schwab, founder and former CEO of the World Economic Forum. In this new stage, digital products and operations take precedence and computerised manufacturing is combined with smart technologies in such a way that virtual and physical systems of products, value chains, and businesses cooperate with each other in a flexible and global way.
Therefore, the strategy to better ‘play’ the upcoming cycle, with the primary objective of investing in equities, and as a complement to it and within it, alternatives in general and technology in particular, will help form a diversified and attractive portfolio capable of generating returns above inflation. This is reflected in PitchBook’s Q3 2021 “Benchmarks” report, which shows that venture capitals over 10 years have consistently outperformed other alternative assets.
Private equity geared towards technology has basically two ways to invest: depending on the investors’ risk profile and the diversification they want to obtain. We understand that a more conservative investor will feel safer investing through a fund of funds, where the risk of a direct exposure to the asset is mitigated, as these are vehicles where there are on average 15-20 funds, which in turn invest in 15-20 companies, making the portfolios quite diversified with about 350 underlying companies; a very high diversification tends to ensure annual net returns in excess of 10%, higher than the current inflation.
For investors who want to have more direct exposure to assets, we believe there is a niche market in FCR vehicles (like the fund of funds) that invest in small and medium-size technology companies listed on European alternative markets, that generate recurring cash, are not leveraged, and where the management team can work together with them to develop the company to the next level.
It should be remembered that these vehicles, known as venture capital funds, have a bonus in the case of legal entities that make the investment highly attractive.
In summary, and in conclusion, we believe that including technology in portfolios is a natural alpha generator and, as the graph below shows, when investing in technology, diversification is fundamental as it significantly reduces the dispersion of returns.
Today, no one disputes that technology is the economic driver of this new era of humanity. And that diversification is the indispensable strategy for investing in technology stocks in a successful mixed portfolio in these uncertain times.
Source: “Can Investors time their exposure to Private Equity?” Página 29, Ed 2019. Chicago Booth University, Oxford University, Duke University, The University of Virginia, University of North Carolina, and Burgiss Private Capital Database