Appropriateness and feasibility of targeted diversification in a private equity portfolio

Abstract

Diversification tools such as modem portfolio theory are used by institutional investors when making asset allocation decisions, which often result in an allocation to the private equity asset class. While some level of diversification within a private equity portfolio, in theory, should produce higher risk-adjusted returns, in practice it is problematic. Through a combination of quantitative analysis of historical private equity returns and qualitative analysis of the investment programs of several large institutional investors with long histories in private equity, the appropriateness and feasibility of targeted diversification is evaluated. The research indicates that the success of private equity investment programs is influenced more by the quality of the managers in the portfolio than by strategic design. Therefore, the ability of investors to access strong performing managers, and to choose not to invest when such access is not possible, is paramount. That said, institutions generally maintain some level of diversification in their portfolios. However, they often do so on an opportunistic basis or within a policy that affords them sufficient flexibility to overweight an area that offers the best expected returns.