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Generating Superior Performance in Private Equity: A New Investment Methodology

A popular focus of research in the area of private equity (PE) portfolio management has been the quest for successful ex-ante identification of individual private equity funds (or “manager selection” within a portfolio). Outside of that, much of the existing research has mainly focused on answering the question of how much of one’s overall portfolio should be allocated to “alternative asset classes” like private equity, and not necessarily on how to manage the actual allocation itself. This lack of examination – likely caused by a deficiency of publicly available data – is in stark contrast to the abundance of research surrounding the application of Modern Portfolio Theory (MPT) and asset-allocation “best-practices” to traditional asset classes such as equities and fixed income.The aim of this paper is to explore the application of some of the key principles of Modern Portfolio Theory (MPT) to private equity portfolio management. We focus namely on the concept of the Efficient Frontier and the idea that optimal diversification – in this case, between risk-type factors – can help enhance overall returns for a given level of overall portfolio risk. To test our hypothesis, we have developed an investment algorithm to evaluate the PE portfolio selection decisions of several large, sophisticated institutional investors over a recent period of 7-10 years. The algorithm reviews the investment decisions faced by the investors, and selects investments that move the existing portfolio closer to the Efficient Frontier using a subtractive process, thus creating an alternate “modified portfolio”. Essentially, any decision that does not improve diversification, reduce risk, or improve a priori expected return, is eliminated. The results show that this even this basic “naive” (albeit, systematic) asset allocation process can improve portfolio performance, in some cases quite dramatically. As such, the practical application of this experiment is not to provide an exhaustive framework for PE portfolio management. Instead, our aim is to pave the way for further research in developing a more robust framework for PE portfolio construction, one that moves away from the relentless focus on manager selection by instead focusing the tenets of traditional of asset allocation.