Portfolio construction is a difficult exercise: how to optimize the performance of a set of assets within the constraints set by a specific risk threshold and a liquidity target? A rather classic approach consists in identifying investment categories, by looking at their intrinsic features and their behaviour under stress (such as a variation of inflation rates or a change in interest rates). The second step is then to look at their historical mutual interactions and trying to forecast them. The purpose is to minimize the risk of the portfolio, usually measured by the volatility of portfolio performance. Ideally, a good portfolio construction would minimize the risk while reaching the performance target. This is done by portfolio modelling, leading to the construction of statistically random portfolios of assets until a series of viable ones emerge, from which executives can choose.

The logic of portfolio construction can be applied to private equity. Investment strategies have different characteristics, some providing income (mezzanine for example), others capital gains only (venture capital for example). The location of funds also has an influence on the risk-return profile of funds as well. Macro-economic and entrepreneurial dynamics are determinants of the behaviour of funds, as well as the legal and cultural factors. As a consequence, certain regions are not favourable to the development of certain strategies.

When is a category relevant for portfolio construction in private equity? Investment strategies are rather well documented, so it is possible with a minimum of effort to forge an opinion. Geographical categories may be subject to more debate: because of the sheer weight of North America and Europe (Table 1), the overall allocation looks set to a split between these two regions. North America represents 53.8% of the funds tracked by Pevara, while Europe represents 36.6%. The rest of the world gathers 9.7% of the funds in the sample. It is therefore tempting to leave the debate at that, and declare that the rest of the world represents emerging markets, to follow the lines of demarcation of usual assets.

Table 1 – Benchmark IRR of private equity funds by geographical location

Table 1 – Benchmark IRR of private equity funds by geographical location

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