Private Equity Portfolio Construction

The returns of a private equity fund are driven by the fund manager, how the portfolio is built and how capital is invested.  Funds that perform in the top 25% earn returns that are twice as high as the average fund.  It is important to find and retain these managers.  In a prior article, researchers had found that a successful fund manager continues to outperform.

The manager has to balance between risk and returns when constructing the fund's portfolio.  Diversification of holdings may reduce risk.  The manager may use the traditional or core-satellite method.  Traditional diversification requires investing in the best assets based on returns, risk and correlation potential.  The core-satellite method has a diverse and low risk portfolio to generate stable returns as its base.  The satellite investments are small and riskier than the core holdings.  They are to add extra return.  This approach allows diversification with extra returns, ability to customize portfolio to specific investor goals, ability to obtain desired levels of exposure to certain risks and ability to concentrate on the satellite investments.

An investor builds a portfolio by using a bottom-up, top-down, mixed or naive approach.  In the bottom-up method, the investor identifies the best managers through screening, due diligence and analysis.  Then investments are made across the highest ranked funds.  However, this may lead to an unbalanced portfolio.  As an analogy, during the technology bubble, the highest ranked mutual funds had large holdings in the same sector.  Even though an investor may have directed capital to multiple funds, there would be little diversification in the portfolio.

In the top-down method, the investor selects sectors or strategies that will outperform.  The general macroeconomic picture will be predicted to determine the asset allocation of the portfolio that will perform the best.  Capital can be spread among different countries, strategies or sectors.  A disadvantage of top-down is that there are not enough good managers to achieve the desired asset allocation.

The mixed method combines the other two.  This involves identifying the top funds and diversify across different strategies.  The naive method invests in all funds of the portfolio equally.

Generally, investing in 20-30 funds can achieve diversification.