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.
It is possible to invest directly in privately-owned companies. Unfortunately, most investors lack the relationships, expertise, and resources necessary. Even those with access may be unable to source attractive investments, conduct due diligence, or negotiate and structure the transaction, and monitoring a private equity investment can prove challenging.
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, with minimums for direct investment in 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 registered funds, which allow individual investors that meet (less stringent) investor qualifications to access private equity funds by investing as little as $25,000.
But how should an investor select a private equity manager and fund?
Manager selection is crucial in private equity, as 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.
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 its 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 the light of factors such as:
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.
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.
Assess the manager’s strategy and, to the extent possible, confirm that the “go forward” strategy is consistent with past practices. A common concern for institutional 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 to be 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.
How has the fund manager created value with past opportunities?
There are three primary “value creation” drivers—and they are not mutually exclusive:
Once you determine the source of a fund manager’s returns, you must consider whether they are coherent and repeatable. Will the same investment professionals that led the last fund also lead its successor?
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, as well as the team’s continuity and experience working together effectively and ability to identify strong management teams for portfolio companies.
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 strongly 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.
To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each include a comprehensive customer PowerPoint about the topic):
©2022. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
Nick Veronis is co-founder and managing partner of iCapital Network, where he oversees the firm’s Research & Due Diligence functions. Mandy Peacock is Vice President, Due Diligence & Origination at iCapital Network.
Please log in again. The login page will open in a new tab. After logging in you can close it and return to this page.