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CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition by CAIA Association

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CHAPTER 8

Private Equity Portfolio Design

The design of a private equity (PE) portfolio can begin once an investor (typically an institutional investor) has decided what portion of his or her total portfolio of assets will be allocated to this alternative asset class and what objectives are set for this allocation. Given the illiquidity of private equity, investors strive to earn returns higher than those of public equity markets. Investors also desire to invest in funds with above-average returns, because an important part of the perceived risk of private equity is that of investing in a fund that underperforms both the private equity and the public equity benchmarks.

8.1 THREE APPROACHES TO PRIVATE EQUITY PORTFOLIO DESIGN

Private equity portfolio design is usually described as either bottom-up or top-down. The bottom-up approach is based on fund manager research, in which the emphasis is on screening all investment opportunities in the targeted PE markets and picking the perceived best fund managers. A top-down approach analyzes the macroeconomic conditions surrounding the targeted PE markets and then determines the strategic asset allocation (i.e., the combination of industry sectors, countries, fund styles, and so on, that are best for meeting the PE program objectives under the likely scenarios).

While appearing to be in opposition, the bottom-up and top-down approaches are complementary and are typically used in tandem. This method, called the mixed approach, either starts ...

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