How to Select PE Investments

Larry Swedroe Private equity (PE) has become a staple of institutional portfolios, but its performance has often been disappointing. New research shows that the levels of specialization and portfolio diversification should be important considerations when selecting a manager to implement a PE strategy.

Over the past 40 years, the private equity (PE) industry has grown rapidly. Attracted by the glamour and potential for lottery-like returns, global PE assets under management reached $4.2 trillion by 2022, and are typically a significant component of the portfolios of many insurance companies, pension funds, university endowments and sovereign wealth funds. But because of minimum net worth requirements, most individual investors don’t have direct access to the asset class.

Private equity (PE) involves pooling capital to invest in private companies either in the form of venture capital (VC) to startups or by taking over and restructuring mature firms via leveraged buyouts (LBOs). Investors who use PE believe the benefits outweigh the challenges not present in publicly traded assets – such as the complexity of structure, capital calls, illiquidity, higher betas than the market, high volatility of returns (the standard deviation of private equity is in excess of 100%), the extreme skewness in returns (the median return of PE is much lower than the mean [the arithmetic average], lack of transparency and high costs. Other challenges for investors in direct PE investments include performance-reporting data that suffer from self-report bias and biased NAVs, which understate the true variation in the value of PE investments.