Diversified vs Specialized Private Equity Funds : A Study of Risk-Adjusted Performance using Insights from Simulations and Empirical Data

Private equity funds face constraints on the number and type of investments they can hold due to the time and resources required for counseling activities. This may lead to specialization in a specific industry or region and leave the funds vulnerable to significant idiosyncratic risk. This research analyzes the risk-adjusted performance of specialized and diversified private equity funds using simulations and real-life data. The simulations aimed to uncover if it was possible to detect the minimum return thresholds for specialized funds given their risk exposure. The results from the simulation model, where various types of specialized private equity funds were simulated by combining previous research with stock market data, were used to formulate a general model that estimated the minimum required IRR for private equity funds. Finally, the estimated minimum IRR was compared to the actual return of various private equity funds to analyze the return of specialized funds relative to diversified funds. The analysis revealed that the simulation model did not consistently detect the minimum return thresholds for specialized private equity funds. In addition, an analysis of historical private equity data was conducted to better understand the effect of diversification on risk and return in private equity. The analysis of historical data, using a data sample of 1,656 fully liquidated deals from Preqin, indicated that specialized funds do not consistently outperform diversified funds on a risk-adjusted basis, possibly due to diminishing returns to scale. However, it appears that the market for specialized private equity funds is relatively efficient, as investors are able to identify and invest in the most promising specialized funds, resulting in competitive returns. The prevalence of specialized private equity funds may be due to the diverse investment needs and strategies of limited partners or investors in private equity funds.