Right-sizing private equity in a portfolio

Private equity has evolved this century from a niche institutional asset to a more mainstream option, now representing 8% of the global investable equity market, up from 1% in 2000. The number of U.S. companies backed by private equity has multiplied and private equity fund formation has surged, reflecting both industry maturation and growing investor demand.

Driving the upswing in private equity’s popularity is its potential to enhance long-term portfolio returns. That potential stems from its opportunity to capture liquidity risk premia and manager alpha while also broadening equity market exposure.

A number of structural challenges mean that adding private equity to a portfolio in pursuit of higher overall returns merits careful consideration. These challenges include:

• Liquidity constraints. Private equity is harder to buy and sell than public equity, so funds that offer access to private equity do not provide the same level of liquidity.
• Appraisal-based valuations. Valuations are not market‑priced, which can understate risk and overstate diversification benefits.
• Manager-specific risk. Returns are highly manager‑dependent, with wide dispersion between top‑ and bottom‑performing funds.
• Uncertain cash flows. The timing and size of investor cash flows are unpredictable and determined by the manager for drawdown funds.
• Framework limitations. Many standard portfolio construction approaches fail to fully account for private equity’s liquidity, valuation, and active risk characteristics.

As an example of these challenges: Private equity can provide a modest diversification benefit by broadening a portfolio’s equity market coverage, but appraisal-based pricing can overstate this benefit if values appear artificially stable. When adjusting for appraisal bias, private equity’s historical performance drops in line with that of public equity during market downturns like the tech bubble in the early 2000s, the 2008 global financial crisis, and the onset of the COVID-19 pandemic in 2020. Thus, while private equity can broaden market coverage, it shouldn’t be relied upon as a risk-off hedge.

Vanguard’s approach emphasizes structured analysis, factoring in return drivers, liquidity constraints, cash-flow uncertainty, manager dispersion, and an investor’s tolerance for systematic, liquidity, and active risk.

When realistically modeling volatility, active risk, and liquidity constraints, the appropriate allocation to private equity can vary widely—from 0% to 40% of a portfolio’s total equity—depending on an investor’s ability to:

• Accept illiquidity;
• Tolerate higher active risk;
• Identify and access highly skilled managers at a reasonable cost; and
• Diversify across investment styles and managers.

As a result, private equity can be a meaningful allocation, but it is not always a suitable option, even for otherwise qualified investors.

Private equity offers significant potential but requires strong due diligence, realistic expectations, and appropriate risk tolerance from investors. When evaluated through a disciplined, evidence-based framework, private equity’s potential benefits can be weighed against meaningful liquidity and active risks. A right-sized approach—grounded in rigorous manager selection, liquidity awareness, and thoughtful portfolio integration—can enhance outcomes for suitable investors, ensuring a proper fit.