Size Matters – Small is Beautiful : The Impact of Portfolio Diversification and Selection on Risk and Return in Private Equity

This paper analyses the fundamental drivers of risk and return in portfolios of private equity fund investments. We draw on a large data set of 771 mature European and North American primary buyout funds with historic performance information from Preqin covering vintages from 1998-2007. Using Monte Carlo type simulation techniques with different sets of 1000 randomly drawn portfolios of varying characteristics from this data set, we document how portfolio design decisions related to the number of underlying primary fund investments, their geographic focus, their size focus as well as the selection ability of the investor influence the risk/return characteristics. Our findings point to the importance of diversification across multiple underlying funds as an important tool to mitigate capital risk, while the marginal returns to increasingly large portfolios are rapidly decreasing. We further document that this risk mitigating impact of portfolio diversification is visible across all subsamples of funds with different geographic focus and different fund size categories. Interestingly, however, our results point to the superiority (in terms of risk and return) of a more broadly diversified small/mid-cap strategy over a less diversified large-cap strategy to put a given amount of capital to work in private equity, but only as long as investors can be sure to access (exclusively or partially) above-average performing private equity funds. In case an investor's selection ability is below-average a concentrated portfolio of a few large funds is superior to an optimally diversified small/mid-cap strategy in terms of the average return. From a risk standpoint, however, the diversification effect of an optimally small/mid-cap portfolio is highly pronounced compared to a concentrated portfolio consisting of a few large funds. Moreover, the superiority of a more optimally diversified small/mid-cap strategy applies in particular for European small/mid-cap funds