6 Things to Consider When Selecting a Private Equity Investment

Most investors are familiar with the public equity market. However, there is a second, much larger market — the private company market — that has the potential to provide outsized returns and portfolio diversification through private equity investments.

Investing in Private Equity

It is possible to invest directly in privately owned companies. Unfortunately, most investors lack the relationships, expertise, or resources. Even those with access may be unable to source attractive investments, conduct due diligence, and negotiate and structure the transaction. Furthermore, monitoring a private equity investment can also prove to be a challenging and time consuming activity.

Instead, most investors gain exposure to private equity through a fund. Private equity funds offer professional management and greater diversification than a single asset — think a mutual fund versus a stock.

Gaining access to private equity funds has historically been difficult for individual investors, even those who meet stringent investor qualification requirements, with minimums for direct investment in traditional closed-end private equity funds typically around $5 million. However, increasing numbers of managers have offered pooled feeder funds with lower investment minimums that typically range from $100,000 to $250,000. Minimums are even lower among the emerging universe of innovative SEC registered funds, which allow individual investors who meet less stringent investor qualifications to access private equity funds by investing as little as $25,000. These so-called Evergreen Funds are continuously offered, have desirable albeit limited liquidity features, and are increasingly managed by well-established and high-quality investment managers.  Also, unlike traditional closed-end private equity funds, which invest for a finite time period, they are perpetual.

Due Diligence

But how should an investor select a private equity manager and fund?

Irrespective of the investment vehicle, whether a traditional closed-end fund, a feeder fund, or an Evergreen Fund, manager selection is crucial in private equity. Returns depend entirely on a manager’s ability to successfully find, improve, and exit investments. While there are many factors to consider as part of due diligence, the following are six essential areas to examine when selecting a private equity manager and fund.

1. Track Record

The track record of a manager is usually the first thing to examine, but you should always analyze a track record in both absolute and relative terms. Whenever possible, use both quantitative and qualitative analyses to interpret manager performance and make sure to benchmark returns appropriately. Look at which benchmark or set of benchmarks a manager uses to assess their own performance. It is also wise to examine the fund manager’s loss ratio and the dispersion of returns among its funds.

Track record analysis should consider comparative performance in light of factors such as:

• Sector
• Strategy
• Geography
• Market environment

In the case of a traditional closed-end private equity fund, it is also important to look at performance through the lens of the year in which the fund was launched — the ‘vintage year.’ Certain vintages have outperformed others due to favorable market conditions, such as weaker economic periods when entry valuations for target assets were lower. As a result, a private equity fund’s returns must be compared with those of funds in the same vintage year that pursued a similar investment strategy.

2. Portfolio Holdings

An often overlooked aspect of due diligence is examining the existing portfolio. A meaningful proportion of the manager’s past investments may remain unrealized when the firm begins raising its next fund. This can sometimes mask a potential deterioration in the overall track record.

Look at the manager’s unrealized investments and try to determine whether they are on track to materially impact the performance of the existing fund – for better or worse.

3. Investment Strategy and Market Opportunity

Assess the manager’s strategy and, if possible, confirm that the ‘go forward’ strategy is consistent with past practices. A common concern for many investors is ‘strategy drift,’ which describes the gradual deviation from the strategy that was responsible for the manager’s past success. Not infrequently, a manager coming off a highly successful private equity investment will raise a successor fund that is far larger, creating pressure to write larger equity checks and ‘drift’ up-market, and ultimately struggle to replicate that past success.

You should think about whether the fundraising target seems realistic. Is it much larger than previous fundraises, and if so, have they added adequate resources to raise, process, and manage that level of funding and to deploy it in the targeted timeframe? In an increasingly competitive market, some private equity funds have struggled to find a sufficient number of appropriate investments at reasonable valuations during the fund’s proposed investment period.

At the same time, it is important to assess whether the same strategy is likely able to deliver in the expected market environment over the investment period of the fund. A trend from which a fund manager benefited may well have run its course. This could impact performance and force the manager to find opportunities in different sectors in which they may have less experience.

For Evergreen Funds, you should assess the ability of the investment manager to invest funds on a continuous basis.  Unlike traditional closed-end private equity funds, in which capital calls only occur when a manager has identified a suitable investment opportunity, Evergreen Fund managers do not control the timing of fund inflows. If the fund invests in other funds, you should examine the potential impact of acquired fund fees on performance.

4. Value Creation

How has the fund manager created value with past opportunities?

There are three primary ‘value creation’ drivers which are not mutually exclusive:

• Financial Engineering: Increasing a company’s leverage ratio or otherwise adjusting the capital structure to boost equity returns;
• Multiple Expansion: Selling portfolio companies at higher multiples than those at which they were acquired; and
• Operational Improvement: Implementing strategies to increase revenue and/or EBITDA during the investment holding period.

Once you determine the source of a fund manager’s returns, you must consider whether they are coherent and repeatable. For example, are the same investment professionals responsible for past performance still in place? If so, are they incentivized to remain?

5. Investment Team

A good investment team is one of the most critical components of private equity investing.

Evaluating the capabilities of the team that will be sourcing, negotiating, monitoring, and exiting the firm’s investments is of the utmost importance. You should thoroughly investigate the backgrounds and experience of the firm’s investment professionals, the team’s continuity and experience working together effectively, and their ability to identify strong management teams for portfolio companies.

6. Deal Sourcing and Investment Process

A good strategy is only as good as an investment team’s ability to execute it.

The investment team’s relationships and networks will contribute enormously to the generation of high-volume and high-quality deal flow, but you should try to fully understand the manager’s deal-sourcing process. Is it handled in-house with dedicated deal-sourcing professionals and sector specialists? Do they integrate proprietary sourcing software, data analytics, or artificial intelligence into the process?

In addition to generating sufficient deal flow, it is critical that a manager has a structured process in place to triage these opportunities and identify how they can add value.

Author’s Disclaimer

This article was written for Financial Poise by Nick Veronis and Institutional Capital Network, Inc. (“iCapital Network”) or one of its affiliates (iCapital Network together with its affiliates, “iCapital”).  This material is provided for informational purposes only and is not intended as, and may not be relied on in any manner as, legal, tax or investment advice, a recommendation, or as an offer or solicitation to buy or sell any security, financial product or instrument, or otherwise to participate in any particular trading strategy. This material does not intend to address the financial objectives, situation, or specific needs of any individual investor. You should consult your personal accounting, tax and legal advisors to understand the implications of any investment specific to your personal financial situation.

ALTERNATIVE INVESTMENTS ARE CONSIDERED COMPLEX PRODUCTS AND MAY NOT BE SUITABLE FOR ALL INVESTORS. Prospective investors should be aware that an investment in an alternative investment is speculative and involves a high degree of risk. Alternative Investments often engage in leveraging and other speculative investment practices that may increase the risk of investment loss; can be highly illiquid; may not be required to provide periodic pricing or valuation information to investors; may involve complex tax structures and delays in distributing important tax information; are not subject to the same regulatory requirements as mutual funds; and often charge high fees. There is no guarantee that an alternative investment will implement its investment strategy and/or achieve its objectives, generate profits, or avoid loss. An investment should only be considered by sophisticated investors who can afford to lose all or a substantial amount of their investment

The information contained herein is an opinion only, as of the date indicated, and should not be relied upon as the only important information available. Any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets is not necessarily indicative of the future or likely performance. The information contained herein is subject to change, incomplete, and may include information and/or data obtained from third party sources that iCapital believes, but does not guarantee, to be accurate. iCapital considers this third-party data reliable, but does not represent that it is accurate, complete and/or up to date, and it should not be relied on as such. iCapital makes no representation as to the accuracy or completeness of this material and accepts no liability for losses arising from the use of the material presented. No representation or warranty is made by iCapital as to the reasonableness or completeness of such forward-looking statements or to any other financial information contained herein.

Securities products and services are offered by iCapital Markets, an SEC-registered broker-dealer, member FINRA and SIPC, and an affiliate of iCapital, Inc. and Institutional Capital Network, Inc. These registrations and memberships in no way imply that the SEC, FINRA, or SIPC have endorsed any of the entities, products, or services discussed herein. Annuities and insurance services are provided by iCapital Annuities and Insurance Services LLC, an affiliate of iCapital, Inc. “iCapital” and “iCapital Network” are registered trademarks of Institutional Capital Network, Inc. Additional information is available upon request.

© 2024 Institutional Capital Network, Inc. All Rights Reserved.

We think you’ll also like:

1. Heeding the Unicorn’s Call: How to Invest in Private Companies as Public Stocks Shrink
2. Invest Tax-Advantaged Retirement Funds in Private Equity for Growth
3. The Delayed Private Equity Exit Strategy – What’s a Limited Partner to Do?

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Structuring and Planning the M&A Transaction
2. Crowdfunding from the Start-Up’s Perspective
3. Dialogue on the Overall Due Diligence

This is an updated version of an article originally published on April 15, 2022.]

©2024. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.