Financial Poise
5 Questions Investors Ask Before Making a Private Equity Investment

5 Questions Investors Should Ask Before a Private Equity Investment

According to Private Equity International, US individuals increased their exposure to private equity by 20% between Q3 2015 and Q3 2016—the biggest year-on-year growth among the largest categories of investors in the asset class. Clearly, this segment of the market increasingly recognizes private equity’s value proposition. That said, it’s important for individual investors to look closely at their investment priorities and educate themselves on the asset class.This includes asking the following five key questions:1. What is my investment timeline and tolerance for liquidity?2. Am I comfortable with the fees?3. How do I research and evaluate private equity opportunities, and can I access top-quartile managers?4. What types of strategies and allocations make sense based on my existing portfolio holdings and risk tolerance?5. Once I invest, how does reporting work?

1. Illiquidity

True private equity is the ultimate in active management.Skilled private equity managers can:

  • effectively anticipate industry trends,
  • identify companies with opportunities for growth and
  • implement value creation strategies such as reducing operating expenses, optimizing asset utilization or making accretive add-on acquisitions to generate superior returns over time.

However, sourcing the right deals, executing operational improvements and successfully exiting investments requires time. Capital lockups are, by definition, required to produce the illiquidity premium for which private equity is known.

Family offices and endowments allocate aggressively to private equity. According to Cerulli, family office allocations to PE average around 26%; the average endowment allocation is about 12% (although leading endowments such as Yale seek to allocate as much as 50% of their portfolios to illiquid assets).

However, these investors have indefinite investment horizons and thus a high tolerance for illiquidity.

Note that the term “private equity” can encompass a wide range of strategies within an illiquid structure. These include:

  • buyouts
  • venture capital
  • private credit
  • real estate
  • infrastructure.

Buyout funds typically have 10-year terms that enable managers to effectively create value. Credit-oriented strategies can have shorter terms of three to five years (and often offer a current income component that helps mitigate their illiquidity).

Particularly for longer-lived PE strategies, assets earmarked for retirement—as well as those intended for intergenerational wealth creation—can be a good fit to fund allocations. However, ensuring a thorough understanding of private equity’s “drawdown” structure is critical when determining how much illiquidity you can afford.Investors in a private equity fund agree to invest a set amount of money (making a “capital commitment”). Unlike in public market investing, the capital does not get invested right away. Rather, the fund manager finds companies in which it seeks a stake. Then, it collects a portion of the commitment via a capital “call.” While investors do not need to fully fund their commitment upfront, defaulting on capital calls can carry serious penalties, including forfeiture of any dollars funded to date. Investors must manage their cash to meet calls when due. Investors receive distributions later in the fund’s life, after investments are recapitalized or sold.

2. Private Equity Fees

Private equity funds typically charge annual management fees of 1.5 to 2% of committed capital. While higher than the fees associated with many passive public funds, good PE managers take a very active role in the management of their portfolio companies.

A key difference between traditional public funds and private equity is PE’s inclusion of carried interest—generally 20% of a fund’s profits. Carried interest serves as a performance or incentive fee for the manager. Because it represents the lion’s share of the manager’s compensation in connection with a given fund and is only paid if the fund achieves a certain threshold or “preferred” return (typically 8%), it aligns the interests of the manager with those of investors.

3. Due Diligence

While traditional public investments are largely beta-driven with low dispersion across managers, private equity returns are driven by manager skill. There is significant dispersion between individual fund returns.According to a recent KKR report, the spread between top and bottom quartile managers in buyout and venture capital is about 10%, compared to just 2% for US fixed income and public equity managers. This makes informed manager selection critical.

Step 1: Comparing the fund returns of a given manager with those of funds of comparable size and strategy in the same vintage year (the year a fund makes its first investment) is the first step in a manager evaluation process.Step 2: Once benchmarking shows a manager to be consistently top-quartile, investors must proceed to determine the key factors that drove prior success. Find out if those factors still exist and appear relevant going forward. This includes evaluating how a manager has created value; adjusting a company’s capital structure via financial engineering and selling a company at a higher multiple than that for which it was acquired tend to be market-related factors that can expose undisciplined managers when conditions deteriorate. (On the other hand, increased revenue and EBITDA across the portfolio is strong evidence that a manager can deliver private equity alpha.)

Step 3: In addition to understanding how value was created within individual portfolio companies, institutional diligence necessitates disaggregating a fund’s overall cashflows to analyze performance by attributes such as:

  • sector
  • equity check size
  • source of investment
  • geography
  • lead investment professional.

These analyses reveal qualitative insights. Investors find out whether a manager’s overall returns came from a particular industry or secular trend (which may no longer be attractive), for example. This enables investors to ask the right questions, such as whether a particular sector will be more or less of a focus in the next fund.

     Tip: Finding Top-Quartile PE Managers

You’ll find a wide dispersion of returns among private equity opportunities. That’s why investors considering the asset class must ensure that they have access to high quality, top-quartile managers.In a stark illustration of the importance of manager selection and access, CalPERS’ Head of Research recently disclosed that the pension’s top 40 managers (out of a stable of 350) produce about 90% percent of the PE portfolio’s total gains. Historically, individual investors struggled to get into top quartile funds, given short fundraising timeframes, high minimums and a willing roster of institutional investors willing to meet these requirements based on historical performance. However, the industry increasingly recognizes the importance of the individual HNW investor market, and new platforms are emerging to facilitate HNW investment into private equity.

4. Creating an Allocation

Traditionally, investors think about allocations by asset class. Public equity vs private equity. Public debt vs private debt. And so on.For an alternative approach, think about private drawdown strategies within the context of equity vs credit vs real asset exposure. In other words, consider how much of your total portfolio can be locked up for longer terms. Then, allocate that illiquid bucket across strategies according to your goals and risk tolerance.

For example, investors looking to achieve higher returns from their equity exposure might consider adding a growth equity fund (or a top-tier venture capital fund, if they can tolerate higher risk).In today’s environment, investors may also be interested in surpassing the anemic yields offered by traditional fixed income. Some strategies, such as private direct lending and structured credit, can be accretive in this regard. UHNW investors allot almost half of their overall fixed income allocations to private credit, according to a recent survey. Direct lending itself offers a variety of risk/return profiles, with some firms focusing on senior secured loans and others making riskier, but higher coupon, subordinated loans.

To provide another example, many individual investors have REIT exposure within their real asset allocation, even though REITs have performed more like stocks than real estate historically. Investors seeking a true inflation hedge with low volatility as part of their real asset allocations might consider private real estate funds. These offer a range of risk/return profiles from core-plus to greenfield development.

5. Reporting

Private equity managers report returns and significant portfolio developments to their investors on a quarterly basis. That said, illiquid holdings are inherently difficult to value. It can be hard to quantify a manager’s impact on underlying investments until those investments are sold. This is why thorough due diligence is key prior to investing.Investors who seek constant reassurance on performance via daily price quotes or frequent reporting should generally look elsewhere.

Quarterly reports disclose four fund metrics:

1. IRR (Internal Rate of Return)

2. Total Value to Paid In Capital (TVPI)

3. Distributed to Paid In Capital (DPI)

4. Residual Value to Paid In Capital (RVPI).

The IRR, which investors should always assess net of fees, is a time-weighted return that takes into account the amount as well as the timing of fund cash flows. However, the timing of inflows and outflows can impact IRR dramatically. TVPI, which simply divides the total realized and unrealized value of the portfolio by the amount of capital invested, is a useful complement.TVPI effectively acts as the fund’s investment multiple. You can calculate it by adding DPI and RVPI.Calculate DPI by dividing cumulative distributions by paid in capital. This ratio grows over time and becomes more relevant as a fund matures.Calculate RVPI by dividing the fair market value of a fund’s unrealized, or “residual”, investments by paid in capital. RVPI shrinks over time, as the fund sells investments. The higher the RVPI, the greater the potential to realize additional gains over time.

Is Private Equity for You?

Individual investors must take many things into account when incorporating private equity into their portfolios. Given the wide dispersion of private equity returns—and the fact that investors’ funds remain locked up for 10 to 12 years—rigorous due diligence is essential. For those investors with the requisite assets, time horizon, risk tolerance and access, private equity can add meaningful diversification and return enhancement potential to a traditional portfolio.

Read more: The Many Challenges Ahead for Private Equity Investing

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About Caroline Rasmussen

Caroline Rasmussen is vice president at iCapital Network, an online alternative investments platform for high-net-worth investors and their advisors. Before joining iCapital, Rasmussen was an Associate in the Project Finance practice of Milbank, Tweed, Hadley & McCloy LLP, where she advised lenders and sponsors on energy and infrastructure project financings. She holds a J.D. from…

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