PE 101: Portfolio Construction and Diversification

How one constructs their investment portfolio is incredibly important. It's no different when investing in PE and VC funds where portfolio construction plays a crucial role in managing risk and optimizing returns. By diversifying your investments across different fund types, industries, geographies, and vintage years, you can enhance the potential for long-term success. In this post, we will delve into the important considerations for constructing a well-diversified portfolio of funds and guide you through some of the key aspects of private equity portfolio construction and diversification.

Defining Portfolio Objectives
The first step in portfolio construction is to clearly define your investment objectives. Identify your desired outcomes, risk tolerance, and time horizon for your private equity investments. Are you trying to build your nest egg for retirement? Or are you saving up for a down payment? These are drastically different objectives requiring vastly different portfolios where PE/VC funds may or may not work well. Establishing why you're investing will help you establish a foundation for constructing a portfolio that aligns with your financial goals.

Asset Allocation and Portfolio Optimization
Determining your unique, appropriate allocation to private equity within your overall investment portfolio is crucial. As a point of reference, when building endowments, university endowments allocate about 30% of their portfolio to PE and VC according to a 2022 study (see image below).1 When thinking about how much you want to allocate, consider your risk appetite, need for liquidity, return expectations, and correlations with other asset classes. It is likely not a coincidence that endowments allocate roughly 30% to PE and VC considering that Partners Group found "modern portfolio theory suggests an optimal private equity allocation in the range of 10-30% for an unconstrained investor depending on risk tolerance".2

Fund Selection Strategies
Once you know roughly how much you want to allocate to PE and VC funds and which type of funds you want to allocate to, selecting the right funds is the next critical piece of the portfolio construction puzzle. It is important to conduct thorough due diligence on potential funds to evaluate their investment strategies, track records, and performance. Assess the fund's investment team, their expertise, and their ability to execute the strategy effectively. Choose funds that align with your investment goals and risk profile. How to diligence a fund is an entire article onto itself which we have previously written about in more depth here.

Diversification is extremely important when choosing funds to invest in and managing risk. There are several different ways one can diversify a portfolio of funds; some of the major ways being the type of fund, geography, sector focus, and vintage.

First, diversifying your portfolio across different types of private equity funds (i.e., buyout, venture capital, and growth) is very helpful for risk management. Each fund type offers unique risk-return characteristics, and spreading your investments across these different strategies can reduce concentration risk and enhance your portfolio's resilience. We go into more detail on the various types of PE funds here.

Second, geographical diversification is another important consideration in portfolio construction once you have decided how concentrated or spread out you want to be across international and domestic markets. Diversifying geographically can help mitigate country-specific risks and capture a broader range of opportunities.

Third, diversifying your investments across different industry sectors helps to mitigate sector-specific risks or shocks. Think about the recent collapse in crypto markets, for example. Or real estate, a tried and true asset class but one prone to cyclicality which can reward an investor in boon times but punish them when the industry is hurting. Allocating to funds that invest in multiple sectors can reduce the impact of any single sector's performance on your overall portfolio. This can be done through investing in multiple funds which focus on individual and different sectors or investing in funds that are sector agnostic or are investing in many sectors.

Fourth, vintage year diversification involves allocating investments across different years in which funds are raised. Vintage year can have a huge impact on returns. Take, for example, a hypothetical scenario in which you invested all your capital right before the 2008 financial crisis. Chances are, you wouldn't do very well. Whereas, if you invested a little bit over the course of 2007, 2008, 2009, and 2010, you probably would have come out okay as the investments made post-crash were likely to perform better. Understand the impact of the vintage year on private equity performance and consider the risks associated with concentrated exposure to a specific vintage year. Spreading investments across multiple vintage years helps mitigate the impact of market cycles and enhances portfolio stability.

Managing your Portfolio
Effectively managing risk is a fundamental part of portfolio construction. Understand the various types of risks associated with private equity investing, such as market risk, liquidity risk, and operational risk. Implement risk management techniques, such as stress testing and scenario analysis, to evaluate the potential impact of adverse events. Regularly monitor and assess risk exposures to ensure they align with your risk tolerance.

Regular monitoring and periodic rebalancing are necessary to maintain a well-constructed portfolio. Establish a robust monitoring framework to track the performance and risk characteristics of your private equity investments. Review the performance of underlying funds, assess their adherence to investment strategies, and identify any changes that may warrant rebalancing. Revisit your asset allocation periodically to ensure it remains aligned with your investment objectives.

Constructing a well-diversified private equity portfolio is essential for managing risk and optimizing returns as a limited partner. By strategically allocating investments across different fund types, geographies, sectors, and vintage years, you can enhance the potential for long-term success. Regular monitoring and rebalancing of the portfolio are necessary to adapt to changing market conditions and ensure alignment with your investment objectives.



1 NACUBO-TIAA Study of Endowments, 2022.

2 Partners Group, Optimal Private Equity Allocation, March 2011.

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