The lure of better-than-average long-term returns from private equity compared with other asset classes is encouraging a growing number of investors to put larger sums into unlisted companies.

In the period from 1999 to 2001, European and British institutions increased their allocation to private equity funds from 2.5 per cent of total fund assets to 3.6 per cent - a rise of 44 per cent - according to a report on alternative investing by Goldman Sachs, the investment bank, and Frank Russell, the US pension fund consultancy. The report forecasts that the figure will rise to 4.3 per cent by next year.

Recent activity in Europe, such as the $2.92 million (€2.94 million) leveraged buyout at Southern Water, the €2.8 billion deal for Eircom and the €3.7 billion buyout of Jefferson Smurfit - highlight recent developments.

In the US, investors' interest is rising steadily - but from a higher base. In the period from 1999 to 2001, the proportion of total fund assets in private equity rose from 7.3 per cent to 7.5 per cent. It is expected to hit 8.1 per cent in 2003.

Mr Alistair Altham, executive director of Morgan Stanley Alternative Investment PArtners, claims there is now a much wider acceptance of private equity as a "real and proper" asset class for inclusion in institutional portfolios.

"Historically, the addition of private equity to a balanced portfolio increases the overall return for the same measure of risk," he says.

Mr John Mackie, chief executive of British venture Capital Association, argues that a properly balanced private equity portfolio delivers around 500 basis points over returns from quoted equities.

Even so, for many pension fund investors, private equity is a problematic class.

For example, private equity funds generally have a 10-year cycle, which might not necessarily match the liabilities of a pension fund.

Also, pension fund trustees will not have the authority to invest in certain asset classes, including private equity and hedge funds.

If the returns argument is accepted, and if private equity funds continue jealously to guard their performance figures from each other, how should the institutions play the sector?

Some very large institutions devote in-house resources to monitoring and managing private equity investments, while others put money into a fund of funds, allowing experts to spread their investments across a variety of private equity fund managers.

"A fund of funds is the embodiment of a manager selection team," says Mr Altham. "What you are doing is hiring the services of a private equity manager selection team.

"For pension funds and institutions that are not well versed or experienced in private equity to date, the chances are that the fund of funds approach will be the chosen route. But the key is to build a well-diversified portfolio, and that is where the fund of fund option can add considerable advantages."

Mr Geoff Ganung, executive director at Frank Russell, says several factors are driving private equty investment.

"There is an illiquidity premium because institutions have to be compensated for the additional time their investment has to be in the fund." He says private equity is the "ultimate active investment" at a time when pension funds are increasingly attracted to active and activist approaches to investment.

"In private equity, the fund managers are very active in managing and growing the companies [in their funds]. The best private equity groups bring real operaitonal skills to the company.

"They have specialist expertise in management in certain sectors. They are working to build the company to the point where it can be sold on."

Recent estimates from Venture Economics, the US research group, indicate that private equity groups are sitting on large pools of uninvested capital.

The figure is in excess of $150 billion when venture and buy-out funds are included in the equation. One executive of a FTSE company that has a 3 per cent fund allocation to private equity believes this is a cause for concern.

"An avalanche of capital in theory means there will be lower returns, I believe the immediate future is quite bleak. Everyone is desperate to invest and that is not a good recipe."