Introduction
When it comes to private market investments, the allure of high returns can be hard to ignore. Private equity, venture capital, real estate, and private credit often promise outsized gains compared to traditional public markets. However, these opportunities come with unique risks that demand careful evaluation. This is where understanding risk-adjusted returns becomes critical.
What Are Risk-Adjusted Returns?
In simple terms, risk-adjusted returns measure the returns of an investment relative to the risk taken to achieve them. In private markets, where investments are often illiquid and lack transparent pricing, assessing risk-adjusted performance is crucial.
Metrics such as the Sharpe Ratio and IRR (Internal Rate of Return) adjusted for risk offer insights into how effectively an investment compensates for its inherent risks. A high return means little if it is accompanied by outsized risks that could jeopardise your capital during a downturn.
Why It Matters in Private Markets
Private market investments inherently carry risks not found in public markets—illiquidity, regulatory uncertainties, and economic cycles, to name a few. Here’s why focusing on risk-adjusted returns should be central to your strategy:
- Evaluating the Real Cost of Returns
Consider two private equity funds: one delivering a 20% return but concentrated in high-risk startups, and another generating a 15% return through diversified, lower-risk investments. While the first fund’s returns appear superior on the surface, the second fund may offer a better risk-adjusted profile, reducing the likelihood of catastrophic losses. - Navigating Illiquidity
In private markets, investments often have long lock-in periods. Risk-adjusted returns help determine whether the potential gains justify the illiquidity and associated risks. - Mitigating Economic and Sector Risks
Private market investments are often sector-specific and tied to economic cycles. A focus on risk-adjusted returns ensures that your portfolio remains resilient across varying market conditions.
Key Considerations for Private Market Investors
Investing in private markets can be rewarding, but success requires a disciplined approach to risk assessment. Here are some steps to help you navigate this complex landscape:
- Understand the Metrics
- For private market investments, IRR is often the go-to metric. However, it’s essential to evaluate IRR alongside risk factors like leverage, default rates, or geographical concentration.
- Prioritise Diversification
- Spreading your investments across sectors, geographies, and asset classes reduces concentration risk, improving the portfolio’s risk-adjusted return potential.
- Assess the Fund Manager’s Track Record
- The quality of the fund manager plays a pivotal role. Look for managers who consistently demonstrate strong risk management practices and deliver steady returns across market cycles.
- Conduct Stress Testing
- Simulating various market scenarios can help uncover hidden vulnerabilities in private market investments and gauge their impact on overall risk-adjusted performance.
- Seek Transparency
- Transparency is crucial when navigating the complexities of private markets. Understanding the underlying risks, governance structures, and due diligence processes ensures informed decision-making. For more insights, read our article on Lessons in Due Diligence: The Case for Transparency in Private Credit.
How Kingsbury & Partners Can Help
At Kingsbury & Partners, we specialise in helping clients make informed decisions in private markets. Our team rigorously evaluates investments through a lens of risk-adjusted performance, ensuring that opportunities align with your financial objectives and risk appetite.
Through our governance framework and access to global partnerships, we aim to provide clarity in a space often marked by opacity.
The Bottom Line
In private markets, not all returns are made equal. Chasing high returns without accounting for risk can leave your portfolio exposed to significant vulnerabilities. By focusing on risk-adjusted returns, you can maximise your investments’ potential while safeguarding against unnecessary risks.
