The Idiosyncratic Risk of Private Equity Matters More Than You Think

Private equity (PE) has long been heralded as a gateway to outsized returns, attracting both institutional and high-net-worth investors. But beneath the allure lies a risk that’s often overlooked—idiosyncratic risk. Because of the high skewness and high volatility of returns, evaluating the asset class based solely on average performance is dangerously optimistic.

The Hidden Risk in Private Equity

The June 2025 study by Weiguo Xiao, Yunjin Zhang, Fuwei Chi, Kaining Zhang, Wei Yuan, and Yang Liu, titled “The High Cost of Low Diversification: Idiosyncratic Risk and the Attractiveness of Private Equity” shines a spotlight on the risks unique to individual PE investments. Unlike public markets, where diversification across hundreds of stocks is straightforward, PE portfolios are typically much more concentrated. This means investors are far more exposed to company-specific (idiosyncratic) risks.

What the Study Examined

Using a robust dataset from Preqin covering 4,576 private equity funds launched between 1983 and 2012, the authors explored:

• How much idiosyncratic risk PE investors actually bear.

• Whether PE returns adequately compensate for this extra risk.

• The implications for portfolio construction and investor decision-making.

Key Findings

1. Limited Diversification

• The median limited partner (LP) invested in fewer than one PE fund per year.

• Over 70% of LPs invested in less than two funds annually.

• As a result, idiosyncratic risk had a substantial impact on investor returns.

2. High Idiosyncratic Risk

• Even large PE portfolios are far less diversified than typical public equity portfolios.

• Investors remain highly exposed to company-specific risks.

3. Undercompensated Returns

• After accounting for the lack of diversification, risk-adjusted returns of PE are often lower than they appear.

• The expected “premium” from PE may not fully offset the extra risk.

4. Diversification is Critical

• The cost of incomplete diversification is significant.

• Investing in about five PE funds per year (maintaining a portfolio of 50 funds, given a 10-year fund life) nearly eliminates the diversification shortfall—yet only 15% of LPs achieve this.

Their findings led the authors to conclude:

“The fees for fund-of-funds are usually reasonable for small-scale restricted investors who would otherwise bear the substantial idiosyncratic risk from a small number of PE funds. Pursuing managers with strong historical performance increases idiosyncratic risk, which, for most investors, outweighs the incremental improvement in returns.”

Investor Key Takeaways

Don’t Ignore Idiosyncratic Risk: PE’s limited diversification means investors are exposed to risks that can’t be diversified away, reducing the asset class’s overall attractiveness.

Focus on Risk-Adjusted Returns: Headline returns can be misleading. Investors should always consider returns after adjusting for both market and idiosyncratic risk.

Build Better Portfolios: Spreading PE allocations across more funds, strategies, and geographies is essential to mitigate concentrated risks.

How to Minimize Idiosyncratic Risk in Private Equity

One effective way for individual investors to reduce idiosyncratic risk is to invest in “open architecture” PE funds. These vehicles leverage the fund sponsor’s broad network to access a wide range of top-tier, specialist investment partners, providing true diversification.

The study found that funds-of-funds have significantly lower return skewness and standard deviation than direct funds. Examples of such diversified open architecture vehicles include:

• Cascade Private Capital (CPEFX), managed by Cliffwater

• AMG Pantheon Private Equity Fund (P-PEXX)

• StepStone Private Markets (SPRIM™)

• Hamilton Lane Private Assets Fund (PAF)

These funds often feature significant exposure to both co-investments and secondaries, reducing the extra layer of fees associated with primary investments. As evergreen funds, they also avoid the drawbacks of traditional PE funds, such as capital calls and the infamous J-curve effect (initial negative returns before investments mature).

Additional Benefits:

• Enhanced liquidity.

• No capital calls, enabling more effective portfolio rebalancing.

• Investors control their exposure timing, rather than being subject to manager-driven capital calls.

Conclusion

Private equity can still play a valuable role in a diversified portfolio, but the risks are higher—and more nuanced—than many investors realize. By leveraging diversified vehicles and focusing on risk-adjusted returns, investors can harness the potential of private equity—without being blindsided by its hidden risks.

Larry Swedroe is the author or co-author of 18 books on investing, including his latest Enrich Your Future. He is also a consultant to RIAs as an educator on investment strategies.

Full disclosure: I have investments in both Cliffwater’s and AMG Pantheon’s funds.