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5 Questions Investors Should Ask Before Making a Private Equity Investment

Your Due Diligence Checklist

The public market’s popularity has waned in recent years, and more retail investors have since expressed their desire to add a private equity 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.

As COVID-19 brings the economy to a halt, private equity 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 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 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 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. Family offices, for instance, are currently the largest LP contributors to private equity funds, contributing 18% of all capital to emerging fund managers. 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. Performance Attributes: A 3-step Due Diligence Checklist

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 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 cash flows 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.

During the coronavirus pandemic, which will have long lasting implications for businesses and whole industries, McKinsey suggests that social impact companies and the ESG sector may become more popular private equity investment opportunities. Attributes like geography and sector will certainly come into play in your due diligence checklist as you analyze performance.

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. 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.  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 making a private equity 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).

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 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 private equity investment can add meaningful diversification and return enhancement potential to a traditional portfolio.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Basics of Fund Formation and Due Diligence Before Investing. This is an updated version of an article originally published on June 29, 2017.]

©All Rights Reserved. April, 2020.  DailyDAC™, LLC d/b/a/ Financial Poise™

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About Caroline Rasmussen

Caroline Rasmussen is the founder of Antara Life and a past vice president at iCapital Network, a powerful financial technology platform offering simplified access to alternative investments for high-net-worth investors.

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