Private Equity Optimal Portfolio

With proper benchmarking combined with the use of advanced risk-control techniques and portfolio construction tools, Private Equity can  truly contribute to significantly enhance the return to risk profile of investment organizations.


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April 19, 2012: Death of a great investment counselor, Carl H. Otto

Updated: April 20, 2012

Private Equity Optimal Portfolio

Can you apply the state of the art risk-controlled portfolio construction and risk monitoring to illiquid Private Equity? Of course you can! Some of the most successful large investment organizations do.

There has been increased interest in illiquid assets like real estate, infrastructure and private equity by large pension plans, foundations and Sovereign Wealth Funds around the world. From a theoretical point of view, higher risky assets are expected to deliver more return and their diversification potential increases the return-to-risk frontier. Private Equities have become really popular since the financial crisis of 2008.

Expected returns from Private Equities have been disappointing in long term studies. More detail about expected returns from Private Equity can be found here. Nevertheless, when properly selected, private equities have the potential of delivering some extra returns from stock selection and from the extra illiquidity premium.

Traditional risk measures (volatility, correlation and Beta) are all significantly underestimated. Leverage tend to be significant which leads to much higher Beta (vs the market). More detail about risk and leverage in Private Equity can be found here.

Benchmarking Private Equity portfolios

There are continuous debates about the proper benchmark to use for private equities. The properties of good benchmarks are discussed here.

The types of benchmarks used by leading mega-funds fall into three categories: non-public benchmarks, separate public equity benchmarks and integrated benchmarks.

  1. Non-Public Benchmark
  2. Separate Public Equity Benchmark
  3. Integrated
  1. Non-Public Benchmark
  2. The use of a specialized non-public benchmark would be justified if we treat Private Equity as a separate asset class with risk-return properties different from all other asset classes. But Private Equities are exposed to the same common risk factors as public equities and they are highly correlated to them.

    Furthermore, non-public benchmarks do not possess many of the desired Benchmark properties (see "SAMURAI" and Bailey’s properties).

    The risk management function is very difficult to perform since the composition of the benchmark is not known in advance. While a manager's ex-post active return may be large (positive or negative), there is no way one can estimate the ex-ante risk which lead to such active return.

    Such non-public benchmarks suffer from the underestimation of risk and correlation parameters and overestimation of returns due to the backfill bias inherent in constructing them. Any asset mix studies done with such benchmarks will lead to overexposing Private Equities.

  3. Separate Public Equity Benchmark
  4. Since non-public benchmarks do not possess many of the desired benchmark properties and because Private Equities are exposed to the same risk factors as Public Equities, some funds decided to use Public Equity benchmarks.

    The risk management function in such approach is rendered possible as one can calculate the ex-ante active risk of its portfolio at any point in time. Such approach remains possible only for very large mega-fund as even for them, the risk management of sizeable Private Equity deals is very difficult to achieve.

    While the risk management function is possible, it remains very difficult to build a well-diversified portfolio at all time.

  5. Integrated
  6. A few mega funds have introduced an innovative approach to Private Equity management and benchmarking. It starts from a clear understanding of what Private Equity is and what it is not.

    The integrated approach renders the risk management function extremely easy and flexible as it makes use of advanced risk control techniques. The organization considering a significant Private Equity investment can take its decision much faster. Any private equity investment can be done if the extra stock specific return and illiquidity premium compensate for the extra risk of the investment. Such organizations are much more agile and can take decisions much quicker.

    Details about this far superior approach to Private Equity management are available to clients.

So Why all the Interest in Private Equity?

As seen in the first section on Expected Return from Private Equity, the supply/demand imbalance for Private Equity portfolios currently lowers their return potential. Performance fees paid to Fund of Funds, including on their (market) Beta part, contribute to lowering their after fee returns. Suboptimal portfolio construction which does not integrate modern integrated risk control techniques leads to lower return-to-risk profile. So why do we observe all this interest for Private Equity? There are four potential reasons:

  1. Underestimated Risk Measures and Correlations
  2. It is well known that illiquid assets have risk measures and correlations which are underestimated. This is a very attractive property for the managers responsible of Pension Plans and SWF. It makes their apparent risk measure at the whole portfolio level much lower than what it really is.

  3. Smoothing of Returns
  4. It is also well known that illiquid assets are often used to smooth returns. There are no marked to market of these assets. Real Estate and Private Equity investments depend on the infrequent appraisal by specialized individuals or firms. Even if those valuations are made by third parties, they are requested by organizations (pension plan, SWF) that pay the third party firms. As a former certified Real Estate Appraiser, I know that the appraiser has latitude in his assumptions and can deliver an appraisal within a large range of possible values. And it is not unusual for appraisers to receive requests for “modified” or “target” appraisal.

  5. Change of Management and Future Return Enhancement
  6. It has been observed with some large government-linked mega funds that when a crisis leads to a change of the management team, illiquid assets tend to underperform during the year of the change of management with the underperformance blamed on the previous management team. This may come from requests that some assets be appraised towards the lower end of the possible valuation range. Furthermore, it creates the potential for future return enhancements of those assets and future bonuses to the new management team in place.

  7. Fuzzy Benchmarking
  8. Benchmarking public asset classes is straightforward, well understood, with not much room for manipulation or discussion. In Private Equity, benchmarking is still in evolution with no consensus. Various institutions change benchmark at a relatively high frequency. Changing the benchmark to one more closely related to one’s portfolio may be used to reduce active risk – instead of building a risk-controlled portfolio in the first place! How can we interpret a fund outperforming its benchmark by 24% in the first 6 month of a year, then changing the benchmark, and matching the benchmark performance for the rest of the year? Perhaps the change in benchmark was done to lock in the outperformance and at the same time to lock in performance bonuses.


Private Equity investments are highly correlated to similar public equity investments. Their higher leverage and Beta leads to higher expected return – something that could be achieve with a leveraged market exposure. When properly managed, they should be expected to deliver a slightly higher return to compensate for the illiquidity of the investment.

Active Private Equity management shall be a source of potential value added. The higher risk in such investments means that investors need to build better diversified portfolios – yet the tendency in recent years has been to build more concentrated portfolios. This come from a lack of understanding of optimal portfolio construction and risk budgeting and also from improper benchmarking, lack of proper performance attribution and improper compensation of Private Equity managers.

The traditional approach to Private Equity investments makes it difficult if not impossible for even the largest SWF to build diversified/risk controlled portfolios and perform proper performance attribution (particularly when investing in Mega Private Equity deals). In recent years, some leading Mega funds have introduced innovative ways of managing and benchmarking Private Equity investments which solves these problems.

Adding illiquid assets to a portfolio will always lead to the whole portfolio’s risk being underestimated by traditional risk measures. Such underestimation of risk and the smoothing effect on returns should not be the justification for considering such investments. It is not surprising to observe that investment organizations which implemented better benchmarking and portfolio management approaches to Private Equity have experienced higher return-to-risk profile from their better risk budgeting.

For more information on optimal portfolio construction and benchmarking in Private Equity, please contact us.

Dominic Clermont, ASA, MBA, CFA


State of the Art Investment Management