Research study: Size Matters — “Small is Beautiful

In the current low interest rate environment, the "private equity" asset class is enjoying great popularity among investors. Nevertheless, many investors are struggling with the strategic allocation of capital within the asset class. Investors need to make fundamental decisions in their portfolio construction regarding the number of fund investments, the geographic focus as well as the size of the funds. In this context, there is little evidence to date on the extent to which these decisions affect the risk/return profile of a portfolio.

The search for the risk/return characteristics of optimal private equity portfolios is the objective of a research study* conducted jointly by Akina and Prof. Oliver Gottschalg. To obtain valid results, a broad database of 771 European and North American primary funds from the vintage years 1998 2007 was analyzed. From this data set, Monte Carlo simulations are used to generate 1,000 random portfolios. To show the influence of the diversification effect, the portfolio sizes vary (1, 5, 10, 15, 20, 25, 30, 50 or 100 underlying funds respectively). In order to isolate the influence of further factors on returns and risk, the database is subsequently divided into subsets and analyzed.

For each of these portfolios, we calculate the average return as well as the return distribution. The latter is calculated in two ways. On the one hand, we use the traditional approach, which focuses on the spread between the minimum and maximum portfolio return. On the other hand, we choose an approach newly developed by PERACS that graphically depicts the distribution of returns within a portfolio.

An optimally diversified portfolio contains about 15 funds

How much diversification is necessary in a private equity portfolio to significantly reduce risk compared to individual fund investments? Our study results indicate that an optimally diversified portfolio consists of about 15 funds (see Fig. 1). At this size, the diversification effect already takes full effect. In addition, resource-intensive overdiversification is avoided, where the marginal utility in terms of further risk reduction decreases sharply. While for "1-fund" portfolios the return range is from 0.02x to 6x, this is already reduced to [1.2x vs. 2.6x] for 15 funds.