Key Private Equity Considerations for Would-Be Investors

The public market’s popularity has waned in recent years, and more retail investors have since expressed their desire to add a private equity (PE) investment to their portfolio. The SEC’s recent proposal to amend and open the accredited investor definition is one step toward increasing investor exposure to private equity investments, but this exposure does not come without major risk.

Following the havoc of COVID-19 and amidst profound economic uncertainty, firms are changing their strategies, and the PE industry is dealing with complex hurdles. As an investor, it’s vital to know how to evaluate private funds and their fund managers—whether it’s during a pandemic or not. Individual investors must look closely at their investment priorities and educate themselves on the asset class. This includes going through a due diligence checklist that includes the following seven key questions:

1. What is my investment timeline and how does that consider liquidity?
2. What is my risk tolerance overall and do I have the capital to fund it?
3. Am I comfortable with the fees?
4. How do I research and evaluate private equity opportunities?
5. Can I access the top private equity funds?
6. What types of strategies and allocations make sense based on my existing portfolio holdings and risk tolerance?
7. Once I invest, how does reporting work?

Let’s get to work addressing these questions, shall we?

The Illiquidity Challenge in Private Equity

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

• Effectively anticipate industry trends

• Identify companies with opportunities for growth

• Implement value creation strategies (e.g., 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 require time. Capital lockups are, by definition, required to produce the illiquidity premium for which PE is known.

When we talk about liquidity, we mean how much time is required to access the capital you have invested and its returns in terms of cash. Understandably, accredited investors and the Average Joe alike grow concerned when that timeline grows longer.

Even so, family offices and endowments allocate aggressively to PE. Among family offices, for instance, 90% report PE holdings. 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, among others:

• 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).

Private Equity Considerations of Risk Capital and Tolerance

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 PE 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.

All of this adds up to two considerations. Can you stomach the ups and downs? Can your bank account?

Is Private Equity Worth the Price of Admission in 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. This, arguably, justifies their compensation.

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.

Performance Attributes: A 3-step Due Diligence Checklist for Private Equity Considerations

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. This makes informed manager selection critical.

Step One

Compare 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). This is the first step in a manager evaluation process. Have they kept pace? Outperformed? Fallen short? Though incomplete, this can give you a snapshot of how a PE fund has fared to date.

Step Two

Once benchmarking shows a manager to be a consistent performer, 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. This refers to 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 serve as strong evidence that a manager can deliver PE alpha.

Step Three

In addition to understanding how value was created within individual portfolio companies, due diligence necessitates disaggregating a fund’s overall cash flows to analyze performance. This means you don’t just compare fund performance against similarly aged funds. You’re looking at where and how they got there. Private equity considerations include 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.

Access Concerns in Private Equity Considerations

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.

Such performance bars are understandable. After all, would you bet on a horse who only achieved wins 10% of the time? While gambling offers a generally poor analogy for informed investing, this perspective illustrates the motivation behind seeking out the crème de la crème in PE funds.

Historically, individual investors struggled to get into top quartile funds. Between short fundraising timeframes, high minimums, and a willing roster of institutional investors willing to meet these requirements based on historical performance, the line for entry gets very, very long. The industry, however, increasingly recognizes the importance of the individual high-net-worth (HNW) investor market, and new platforms continue to emerge to facilitate HNW investor entry into PE.

Private Equity Considerations in Individual Portfolios

Traditionally, investors think about allocations by asset class. Public equity v. private equity operates as one (albeit unnecessary) dichotomy. Public debt v. private debt is another. It goes on and on.

Balancing a portfolio across different asset classes could not be more important. In terms of your individual portfolio in terms of private equity considerations, though, our previous discussions about liquidity offer a complementary perspective. Think about how much of your total portfolio can or should be locked up for longer terms. Then allocate that illiquid bucket across strategies according to your goals and risk tolerance, which may or may not include a PE allocation.

For example, investors looking to achieve higher returns from their overall 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.  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.

We understand this sounds complicated. Simply put: there are plenty of options out there if you want to diversify illiquid holdings. Private equity, when properly evaluated, can be one such selection.

Understanding Private Equity 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 making a PE investment. 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)

These calculations are far from simple. There’s a reason PE is typically reserved for accredited investors assumed to be savvy. If this is your first foray into PE, you should certainly consult with an advisor to help you navigate the jungle of data ahead – one who is able and ready to do so.

Is a Private Equity Investment 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, a PE investment can add meaningful diversification and return enhancement potential to a traditional portfolio.

If you’re interested in hearing more about private equity, our Due Diligence Before Investing webinar is an excellent place to start. Want to learn more about other distinctive investments? You may find the following webinars interesting:

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For more information about our on-demand webinar series, click here.

This is an updated version of an article from 2020. ©2023. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.