Private equity: Articles

Private equity investment is yet another means of diversifying your wealth, this time by investing in start-up and early stage companies that have yet to list publicly. Private equity managers are typically looking for companies with high growth prospects and a good product or service. They like firms with a competitive edge or unique selling point.

Private equity firms provide financial and strategic support to enable growth companies to turn into the major businesses of tomorrow.

Unlike some of the other asset classes covered by Fintactica, private equity is a long-term investment, where you will be required to commit substantial assets for a number of years before you necessarily realise any profits. Direct investment into private equity funds is only for the extremely wealthy: you should expect to be ready to commit at least US$2 million.

The appeal for experienced private equity investors is that you can get exposure to companies before the market does, i.e. when they are still at a relatively early stage of development. If an investment made by a private equity manager is realised through floatation, the investors in the fund are occasionally offered shares in the newly-quoted company. More usually, the shares are held within the fund until finally being sold by the manager.

Private equity funds

A popular way for investing into private equity is via a fund. Specialised private equity managers raise cash for a fund by asking investors to make 'commitments' to a venture. As an investor, you would become a 'limited partner' in the fund, which would be structured as a limited partnership. You will not be asked for all the cash up front, but will be expected to feed it in gradually over a number of years. The fund will access money that has been committed on an investment by investment basis, generally in the first one to five years of the fund's existence.

There is a wide range of private equity funds available to choose from around the world. They offer the investor a high level of control, with the fund manager more directly accountable to his clients than in other sectors. Fund managers typically take a position on the boards of companies in which they invest in order to keep in close touch with the portfolio firm's development.

Unlike mutual funds or hedge funds, most private equity funds have a definite lifespan - at some point the manager intends to wind the fund up and pass the profits back to the investors. Funds investing in private equity are likely to take longer to repay commitments than those focused on buy-outs. Cash is returned to investors as and when investments are realised - you could receive as much as you have committed originally within a four to six year timeframe. The average life of such a fund is 10-12 years.

Cash is paid back as and when companies in the portfolio are floated on the stock-market. Fund managers will try to realise as much as possible of this in cash for those investors who want it, but be aware that you could end up holding shares from portfolio companies after the fund itself has been wound up. It will be up to you to sell these securities via your own portfolio trading activities.

As an investor you will rarely be required to invest maximum commitment to a private equity fund: the fund concerned will typically 'draw down' between 80%-90% of commitments, although on average a maximum of 60% will be committed at any one time (this level will vary from fund to fund, with some strategies requiring a higher level of commitment). This is why experienced investors in this market will hold several such funds, receiving rolling pay-outs from their portfolio as the various underlying investments are realised.

Specialised private equity managers will tend to raise new funds every three to five years. Fintactica will keep our subscribers abreast of new funds being raised by private equity managers around the world, although it is also worth consulting your private bank or investment adviser, as they may be contacted directly by the venture firms involved.

Getting out early

Some investors, for whatever reason, find they need to exit a private equity fund before it reaches maturity. There is a small but growing secondary market in private equity funds that can offer you a way out of your portfolio prior to wind-up. Most general partners (the managers of the fund) will try to find a secondary placing for an investor seeking to exit a fund. Such secondary trading is undertaken at a discount, however, and should not be relied upon.

Other routes

There are more flexible routes into the private equity market. If you are particularly wealthy, you could employ a private equity manager to run your own 'segregated account', providing you with a higher level of control over your investment, good accountability, and direct contact with the fund manager. You can also tailor the time period to your requirements.

If you don't have the money for a segregated account, a fund of funds is worth considering. These are specialised investors in private equity that invest in a range of underlying private equity managers. Funds of funds can give you access to a diversified portfolio of private equity funds. They will be particularly familiar with all of the private equity managers out there, especially relative performance, methods, underlying portfolios, and scheduled fund raising periods. In addition, like fund of funds investments in other asset classes, it gives you access to a sophisticated portfolio of underlying funds without the expense and administrative workload of doing it yourself. Funds of funds can even get access to those private equity funds that are so well-regarded, they are regularly over-subscribed.

The downside with funds of funds is that you end up paying a double layer of fees (as the fund of funds manager will charge you a fee on top of those charged by the underlying fund managers themselves). You also will not have the same degree of control you would enjoy by investing directly into a private equity fund. You may even need to commit funds to a slightly longer time horizon (potentially up to 15 years).

Listed investment trusts are a much cheaper and more liquid way to move into this market, if you only want to commit a limited amount of capital. Established investment trusts will typically have a high degree of expertise and a quality 'deal flow'. The downside here is that the shares in such trusts may trade at a discount to net asset value (the real worth of the underlying private equity investments), and can end up performing more closely to conventional quoted markets, something you do not want if you're entering private equity because of its diversification benefits.

Choosing a private equity manager

As with other types of investment funds, it is worth scrutinising the historic track record of a prospective manager. Their ability to add value to portfolio companies is also important. Does their expertise help the management of portfolio companies achieve better profits than otherwise? Can they demonstrate ability to move with changing market conditions? And does their investment strategy fit with your requirements? Remember, this will change quite radically from fund to fund. It is also worth thinking ahead ten years: will this fund manager still suit your requirements then?

Fees

The annual management fee for a private equity fund is usually based on the amount of capital that has been committed by you the investor. Fees levied by private equity managers are generally higher than for other asset classes. This is because finding, buying, monitoring, and selling on private companies is a more labour-intensive business than buying and selling listed securities. These higher fees should be balanced against the fact that you are achieving higher returns.

Private equity vs venture capital: a question of definition?

If you are a US investor, or familiar with US terminology, our coverage may confuse you slightly. We use the European definition of private equity on this site, namely as an umbrella term that covers all forms of financing for unquoted companies. Venture capital we consider to be funding for early stage businesses. In the US, private equity and venture capital are regarded as very separate activities.