Most investors are familiar with the public equity market. When it comes to stocks and bonds, prices can reflect new data quickly, and almost everyone is privy to the same information. However, there is a second, much larger market—the private company market—that has 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:
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 that a fund manager’s returns were the result of sound investment selection and operational improvement, you must determine if those are 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:
Another important tip: investigate the fund manager’s loss ratio and dispersion of returns.
Most times, 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.
Assess the private equity manager’s strategy. Learn 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 his 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.
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 instances, a secular trend from which a fund manager benefited may have run its course, forcing the manager to find opportunities in different sectors. The manager may have less experience in these sectors.
A good investment team is one of the most critical aspects of private equity investments Evaluating the capabilities of the team that will be sourcing, negotiating, monitoring and exiting the firm’s investments is of the utmost importance. Prospective investors 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. 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.
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. He must also 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.
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).
[Editor’s Note: Check out these related webinars, which can be taken for Continuing Legal Education (CLE) credit, or simply for practical and entertaining education for business owners, Accredited Investors, and their legal and financial advisors: Alternative Assets Part 1: Investing in Venture Capital, Private Equity, and Hedge Funds, and What is a “Private Fund?” This is an updated version of an article that was published on February 3, 2016.]
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.
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