You are on page 1of 6

NOVUM

May 2015

Size matters small is beautiful


The impact of Portfolio Diversification and Selection on Risk and Return in
Private Equity

A research study* conducted by Prof Oliver Gottschalg (HEC Paris and PERACS) and
Dr Ralf Gleisberg and Ramun Derungs (Akina).

*The comprehensive research study can be requested by contacting Dr Ralf Gleisberg (ralf.gleisberg@akinapartners.com)

Executive Summary
-

Optimally diversified small/mid-cap portfolio is superior in terms of return and risk

Small/mid-cap funds consistently outperform large-cap portfolios (both in EU and in the US)

Strong (risk-reducing) effect of diversification

Optimally diversified portfolio contains about 15 funds

Positive effect of selection both on return and risk

European portfolios with broader return dispersion than North American portfolios

Introduction / Data / Methodology


Private equity has become in the current low interest environment an increasingly popular component
of investors portfolios. Yet many investors still struggle how to best implement their allocation to the
private equity asset class. Investors need to take decisions shaping the design of their private equity
portfolio, including choices about the number of funds, geographic focus and size of such funds. There
is not much reliable evidence on how these choices influence the risk/return characteristics of the
corresponding portfolio.
The research is based on a comprehensive data set of 771 mature European and North American
primary buyout funds covering fund vintage years from 1998-2007 and is provided by Preqin. 1000
random portfolios are created using Monte Carlo simulation methods. Such portfolios consist of 1, 5,
10, 15, 20, 25, 30, 50 or 100 underlying fund(s). This approach is first applied to the overall data set
and then to specific sub-samples e.g. selection ability, geographic focus and market size.
For each of these portfolios, we then calculate the average return of all underlying funds, as well as
the return dispersion. The latter is calculated in two ways. First, we use the traditional approach of
measuring the range of observed portfolio returns between the minimum and the maximum portfolio
returns. Second, we apply a more advanced approach to graphically capture and quantify the portfolio
return dispersion using a novel technique developed by PERACS.

Optimally diversified portfolio contains about 15 funds


Our findings point to an optimally diversified portfolio of about 15 funds. With this portfolio size the
diversification effect comes already into play. While the range between the best and worst possible
outcome of 1000 simulated portfolios with a single underlying fund goes from 0.02x to 6x, already a
diversification across 15 primary funds reduces this range to [1.2x, 2.6x].

6x

PERACS Risk curve overall diversification effect

Average portfolio return &


return dispersion

7x
6.0x

5x
TVPI

4x
3x

2.6x

2x
3

1.2x

1x

1
0x

0.02x

10

15

20

25

30

50

100

Number of underlying funds in portfolio


Average
1
2
3

Positive (risk-reducing) effect of diversification


Decreasing marginal diversification effect (of increasingly large portfolios)
Decreasing risk coefficient with increasing portfolio size
2

Positive effect of selection on both return and risk


Overall, investors fund selection ability has an obvious impact on the average performance. We
observe that the performance of the worst portfolio of above-average funds is higher than the average
return of portfolios consisting of below-average funds. Selection skills show therefore a quite strong
risk-reducing effect. However, not only selection ability reduces risk also diversification is beneficial
from a risk perspective e.g. the worst upper portfolio performance improves from 1.52x to 1.80x
through diversification.

1
2
3

Selection ability has (not surprisingly) an huge impact on the average performance
Worst upper portfolio returns more than the average of lower portfolios (e.g. 1.52x vs. 1.21x)
Worst upper portfolio performance improves from 1.52x to 1.80x through diversification

European portfolios with broader return dispersion than North American portfolios
The average returns of the primary funds in the subsamples from Europe and North America are very
similar. However, the dispersion of returns is greater across European funds than for the North
American peers allowing the European funds to outperform. Adding further funds to the portfolio leads
not only to a convergence of the worst performing European to the North American portfolios but also
results in higher best performing portfolios of European funds. For instance, increasing the number of
underlying primary funds to 15 increases the bottom portfolio to 1.26x in both regions. However, the
best performing portfolio is meaningfully higher in Europe than in North America (2.47x vs. 2.36x).

1
2
3

Higher return dispersion in European funds


Best performing portfolios in Europe
Convergence of the worst performing European to US-portfolios through diversification

Size matters Small/mid-cap portfolios outperform large-cap portfolios


Large-cap funds substantially underperform portfolios made up of mid-cap and in particular of smallcap funds. We observe a related trend when it comes to performance dispersion. Large-cap funds
have a lower return dispersion than small-cap funds.

1
2
3

Small/mid-cap portfolios outperform large-cap portfolios (e.g. 1.73x vs. 1.66x)


and show a higher return dispersion
Increasing diversification leads to over-proportionate risk mitigating effect in small/mid-cap funds

An asset allocation decision


In practice, investors face resource and volume limitations related to how much money they can invest
in small/mid-cap funds. Therefore, they need to prioritise between two investment approaches: either
fewer large funds or more smaller funds. Consider as an illustrative example first a portfolio made up
of five commitments of $45 million each to funds in the large-cap category and second a portfolio
made up of 15 commitments of $15 million each to funds in the small- and mid-cap category.
While both strategies deployed a total of $225 billion, the expected average returns of the large-cap
case are of 1.66x, compared to average returns of the small/mid-cap strategy of 1.72x (or 1.82x in a
pure small-cap portfolio). At the same time, the small/mid-cap strategy is also preferable from a risk
standpoint, as the worst possible outcome of 1000 portfolios favours also the small/mid-cap strategy
(1.27x vs. 0.97x). Taken together, our results indicate that a optimally diversified small/mid-cap
strategy is likely to be superior in terms of risk and (!) return to a concentrated large-cap strategy.
Small/mid-cap portfolio is superior in terms of return and risk

1
2

Optimally diversified small/mid-cap portfolios outperform concentrated large-cap strategy


and is less riskier
4

The above mentioned results left us wondering whether the superiority of an optimally diversified
small/mid-cap portfolio is specific to funds of a certain return category. So we replicated the analysis
separately for subsamples of funds with above- and below-average returns. Interestingly, our results
illustrate that indeed this particular relationship seems to be specific to the better performing funds. In
case an investors selection ability is below-average a concentrated portfolio of few large funds is
superior in terms of the average return. However, from risk perspective a diversified small/mid-cap
portfolio looks still more favourable.
Selection skills lead to stronger outperformance and lower risk

1
2
3

Optimally diversified small/mid-cap strategy leads to outperformance


with more favourable bottom performance
despite having a similar return dispersion.

The results of the research get confirmed when looking at European funds only. An optimally
diversified European small/mid-cap portfolio is less risky than a concentrated European large-cap
portfolio and performs better in terms of both average and peak returns.
Looking at Europe only

1
2
3

Optimally diversified European small/mid-cap portfolio is not only (slightly) less risky
but performs better both on average (2.27x vs. 1.92x)
and with superior peak performance (3.11x vs. 2.48x)

About the authors of the study


Professor Oliver Gottschalg
HEC Paris, PERACS
+
T: 33 670 01 76 64
E: oliver.gottschalg@peracs.com
Prof Oliver Gottschalg current research focuses on the strategic logic and the performance
determinants of private equity investments. His work has been published in leading academic
journals and in various publications for practitioners. In parallel to his faculty position at HEC,
he is affiliated with INSEAD as a visiting researcher and the coordinator of the HEC Buyout
Research program. He holds a Wirtschaftsingenieur Diploma from the University of Karlsruhe,
an MBA from Georgia State University and a M.Sc. and Ph.D. degree from INSEAD.

Dr Ralf Gleisberg
Akina Ltd
+
T: 41 44 220 16 08
E: ralf.gleisberg@akinapartners.com
Dr Ralf Gleisberg is a Partner of Akina. He is responsible for advising on fund investments in
the Benelux and the Nordic countries. He is member of the advisory board of several private
equity funds across Europe. In addition, Ralf has been instrumental in setting up the portfolio
monitoring for Akina advised investment vehicles. He holds a Masters Degree in Economics
from the University of Freiburg (D) and from the University of Michigan at Ann Arbor (USA)
and a Ph.D. degree in Finance from Basel University (CH).

Ramun Derungs
Akina Ltd
+
T: 41 44 220 16 20
E: ramun.derungs@akinapartners.com
Ramun Derungs joined Akina in March 2014 as an Associate. His main responsibilities are to
provide support to the marketing and investor relations front staff. He holds a Master of
Science in Banking & Finance from the Zurich University of Applied Sciences.

About Akina
The Akina Group offers European private equity funds focusing on investing into small and medium size businesses through its
alternative investment manager, Akina (Luxembourg) S.A. and its adviser, Akina Ltd. Since 1999, the Euro Choice flagship
programmes and mandates have attracted over EUR 2.0 billion (USD 2.1 billion) from well over 100 qualified investors around
the globe. The Akina team combines a broad fund and direct investment expertise.
Akina was awarded the Gold Award (2011) and the Silver Award (2012, 2013 and 2014) for best regional investment strategy
by Private Equity Exchange & Awards.
Akina (Luxembourg) S.A. is an alternative investment fund manager (AIFM) registered with the Luxembourg Commission de
Surveillance du Secteur Financier (CSSF). Akina Ltd is an investment adviser registered with the U.S. Securities and Exchange
Commission (SEC). Akina is a signatory to the Principles for Responsible Investment (PRI).
www.akinapartners.com

You might also like