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Most investors are familiar with the public equity market. With stocks and bonds, prices quickly reflect new data and almost everyone sees the same information. However, there is a second, much larger market—the private company market—with the potential for outsized returns and portfolio diversification through private equity investment.
The returns from a private equity investment depend on the manager’s ability to successfully find, improve and exit his or her investments. Carefully evaluate a manager before investing.
Once you find the correct manager, here are seven other things to get right before making private equity investment:
1. Value Creation
Has the fund manager created value with past opportunities?
There are three primary “value creation” drivers—and they are not mutually exclusive:
- financial engineering, which means increasing a company’s leverage ratio or otherwise adjusting the capital structure to boost equity returns;
- multiple expansion, meaning the manager sold past portfolio companies at higher multiples than those at which the manager acquired them;
- operational improvement, usually reflected in increased revenue and/or EBITDA during the hold period.
2. Track Record
Once you determine that a fund manager’s returns were the result of sound investment selection and operational improvement, you must determine if those were repeatable.
In other words, will those elements exist in the next fund?
Whenever possible, rely on quantitative and qualitative analyses to determine historical performance. Focus on attributes such as:
- equity check size
- source of investment
- lead investment professionals
Another important tip: dig into the fund manager’s loss ratio and dispersion of returns.
3. Unrealized Portfolio
Typically, a meaningful proportion of the manager’s past investments remain unrealized when the firm begins raising its next fund. This sometimes masks a potential deterioration in the overall track record.
Look at the manager’s unrealized investments and see if you can guess whether these unrealized portfolio companies are on track to generate returns that will support, or even improve, the current performance of the fund.
While a manager’s track record may be attractive on an absolute basis, it is crucial to compare the firm’s historical performance to that of its peers.
Certain vintage years have outperformed others due to favorable market conditions, such as lower entry valuations for target assets during weaker economic periods.
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.
5. Investment Strategy and Market Opportunity
Assess the private equity manager’s strategy. See how it fits with the expected market environment over the investment period of the fund. If you can, confirm that the “go forward” strategy is consistent with the manager’s past practices; a common concern of institutional investors is “strategy drift,” or deviation from the strategy that was responsible for the manager’s past success.
Strategy Drift: Not infrequently, a manager coming off a highly successful private equity investment will raise a successor fund that is far larger, placing pressure on the manager to write larger equity checks and “drift” up-market.
In other cases, a secular trend from which a fund manager benefited may have run its course, forcing the manager to find opportunities in different sectors in which the manager has less experience.
6. Investment Team
This is critical. You must evaluate the capabilities of the team that will be sourcing, negotiating, monitoring and exiting the firm’s investments. Prospective investors should investigate the backgrounds and experience of the firm’s investment professionals, as well as the team’s continuity and experience working effectively together. The team’s relationships and networks are also crucial in terms of the volume and quality of the manager’s deal flow, as well as the firm’s ability to identify strong management teams for its portfolio companies.
Prospective investors should investigate the backgrounds and experience of the firm’s investment professionals, as well as the team’s continuity and experience working effectively together. The team’s relationships and networks are also crucial in terms of the volume and quality of the manager’s deal flow, as well as the firm’s ability to identify strong management teams for its portfolio companies.
7. Deal Sourcing and Investment Process
A manager’s ability to source a large enough volume of high-quality investment opportunities is key. Many PE firms rely primarily on the strength of their networks to generate proprietary opportunities, while others turn to cold calling programs, brokers and auctions. 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 which companies are best positioned for future growth or are the best candidates for a turnaround strategy.
In addition to generating sufficient deal flow, it is critical that the manager has a structured process in place to triage these opportunities. Find out how the manager identifies those companies best positioned for future growth, or that are the best candidates for a turnaround strategy.
How to Find a Private Equity Investment Opportunity
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. Even 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 mutual fund vs. stock).
Nick Veronis is managing partner and Kunal Shah is senior vice president of the Due Diligence and Origination team at iCapital Network, a financial technology platform offering streamlined access to alternative investments for high-net-worth individuals and their advisors.