Financial Poise
Private Equity investment

An Initiation Into Private Equity Funds

What is a Private Equity Fund?

Most people are familiar with the concept of a stock exchange and publicly traded shares of companies that are listed there. But the private equity market is less well-understood, perhaps because it is dominated by deep-pocketed institutional players like pension funds. But accredited investors may also buy private equities — essentially, shares of companies that are unlisted — by investing in a private equity fund. A large capital outlay is a feature of private equity, where direct investments are made in companies, often with an intention of gaining control and influencing their management.

What to Consider Before Investing in a Private Equity Fund

A private equity fund investment is a long-term commitment, often lasting nearly a decade. That means that it could take a while to see returns or to even quantify their value. Investors have to consider several factors, such as illiquidity, fund manager expertise and fees before taking the plunge. Nonetheless, private equity firms can help you yield high returns.

A Brief History of Private Equity

The modern private equity fund was invented in the 1960s and 1970s in the USA. This asset class comprises venture, growth, and mezzanine capital, leveraged buyouts and distressed debt. The private equity niche started to develop soon after, and a surge of capital in the 1990s drove this niche to the status of a full-grown asset class.

The reason for that influx of capital is of course the thirst for yields. As bond yields and marginal returns on the stock exchange decreased, investors grew more sophisticated and looked for alternative strategies. Private equity was a way to diversify and get exposure to emerging markets and geographies.

So today, the industry has reached a certain maturity, and the risks associated with private equity are better known. However, and interestingly, the historical returns of over 20 percent in the 1980s are no longer assured, as the average net return for investors now is in the region of 12 percent. However, research from Preqin still suggests that private equity outperforms the S&P 500, though not as much as it did before the financial crisis. So, should you invest through a private equity firm, and if so, how?

The State of Global Private Equity

According to research by Bain Capital, the US still produces more start-ups valued over $1 billion (a.k.a. unicorns), but China’s rapidly growing tech sector has attracted over 800 PE investors. Experts warn that this bubble may soon burst due to a saturated market, higher investments and fewer viable exit opportunities.

In the larger global economy, S&P Global predicts slowed GDP growth and decreased private equity activity in North America, Latin America and other APAC countries. Chinese growth will remain moderate, and European growth will remain stable. As tariffs, inflation and other economic conditions affect returns, private equity managers will have to continue to adapt and overcome. These global statistics also imply a growing importance on choosing an experienced fund manager that can predict industry trends and put value into investments.

Who are the Top Ranking PE Firms?

There are between 4,000 and 5,000 known private equity fund managers worldwide. There is no “Bloomberg of private equity,” so we don’t know the real dynamics of the sector, but we do know the main players.. The most successful PE firms in 2019 include:

  • Blackstone
  • The Carlyle Group
  • KKR
  • CVC Capital Partners
  • Warburg Pincus
  • Bain Capital

In venture and growth capital, these are the current big names in the local market:

  • Sequoia Capital (Google, Yahoo!, Amazon, Cisco, etc.)
  • Accel
  • Index Ventures
  • Andreessen Horowitz
  • Benchmark

Private Equity Funds vs. Direct Private Equity Deals

Why would an accredited investor go into a private equity fund, rather than a “one-off” deal to acquire a company where yields are potentially highest? Because it is still a very tough job to invest directly in private companies. It requires a lot of know-how in finding the opportunities, assessing them, negotiating (e.g. a shareholder’s agreement),  monitoring the investments and steering them as the company evolves. Then, of course, selling companies requires a great deal of contacts and M&A expertise.

Accredited investors are better off investing with professional managers through a fund. A PE fund that is properly managed will maximize returns through the expertise of the manager and often additional business experts that manage aspects of the company. These professionals are vital to handling high-risk, high-return investments.

Finding the Right PE Fund Manager

Accredited investors can gain access to the performance statistics of fund managers, some of whom have decades-long track records. We have a lot of documentation about the persistence of individual managers’ returns in private equity, which means — unlike in most asset classes — PE managers’ past performance is a good predictor of future performance. und managers’ success in other asset classes aren’t as “persistent.”

Other elements in the selection of a fund manager are the composition of the management team and their past performance, their strategy, their geographical location, and a set of additional qualitative and quantitative factors. Choosing a suitable fund manager actually depends a lot on who is the investor and what is his or her strategy.

Finally, it is important to understand the dynamic between General Partners and Limited Partners, or fund managers and investors, respectively. For example, immediately after the 2008 recession, GPs struggled to raise capital from hesitant institutional funds, giving LPs greater leverage and more favorable terms. For the most part, this relationship has balanced out once again, but economic conditions can quickly change negotiating leverage.

Private Equity Liquidity, Risk & Reward

We hear that investing in private equity is risky because of the lack of liquidity at both the fund level and the portfolio company level. However, financial assets should be perceived as more or less liquid, rather than liquid or illiquid. It is an illusion to assume that listed assets are liquid. Eighty percent of them are barely traded, and their liquidity can fall dramatically in a crisis context.

If we keep in mind that assets are more or less liquid, then we will also agree  that prices and returns will vary with the liquidity. It is reasonable to expect that you would be rewarded for accepting less immediate access to your capital with a lower price and/or higher return.

It should also be said that private equity funds are less risky than hedge funds. Illiquidity and long-term commitment may seem like downsides to some investors, but these characteristics also make PE funds slightly safer. Hedge funds, in contrast, use riskier methods to get immediate returns.

It can be argued that private equity is less risky, because it’s less volatile, better monitored and better managed than listed assets. Some may find this a radical notion, but I stand by it.

[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?”]

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