Pros, Cons of Investing in Private Equity Funds

April 24, 2014
Paul Jacobs, CFP

Adding private equity funds to your portfolio can lead to higher returns and lower risk over the long term, but choosing a private fund takes much more due diligence than selecting a mutual fund.

Adding private equity funds to your portfolio can lead to higher returns and lower risk over the long term, but selecting a private fund takes much more due diligence than selecting a mutual fund.

Private equity funds are typically limited partnerships with a lifespan of about 10 years. Some have a minimum investment as low as $100,000 and are available to ordinarily affluent people; some are only for the ultra-wealthy. Because these funds are illiquid no one should invest in them unless he or she can easily handle funds being tied up for 10 years or more.

For the right investor, the rewards can be substantial.

Private fund managers can take a more active role with the companies they acquire and potentially wring out higher returns than mutual fund managers. They use leverage (borrowing), which can make for higher returns. Using leverage, the funds buy up companies, and the manager looks to markedly improve operations and profits.

The right manager

Investors should look for managers who generate returns by making significant operational improvements to portfolio companies, rather than those who rely on excessive leverage, which adds risk. However, with judicious use of leverage, a skilled manager can deliver excellent results.

Dig deeply into the manager’s investment strategy to understand it, be fully aware of the particular risks involved, and identify any potential red flags. Understand the manager’s strategy and ensure that nothing about it worries you.

Find out how the manager’s previous fund portfolios were structured and how they expect the current fund to be structured and diversified. How many portfolio companies does the manager expect to own, and what is the maximum amount of the portfolio that can be invested in any one company? A more concentrated portfolio will carry the potential for higher returns, but also more risk.

Fees and costs

Most private equity managers charge a typical 2% annual management fee and 20% carried interest. This is the share of the ultimate profit, often above a specified hurdle rate, that goes to the manager before the remaining profits are divided with investors. Avoid managers who charge more than 20% carried interest.

Be skeptical of funds that do not provide annual audited financial statements or cannot clearly answer questions about where they store cash balances. Feel free to visit the manager’s office and ask for a tour.

An open secret: negotiate

Everything is negotiable. See if you can negotiate for lower fees or a reduced minimum commitment if desired.

Investment advisers now have more tools to make it easier to find how much of a manager’s return was attributable to expertise and operational improvements to portfolio companies, and how much to the macroeconomic environment or leverage.

Some managers aren’t able or willing to provide this information, but for those who are, it can be very helpful in providing a clear measure of how much value a manager added.

Investing in private equity

A rough rule is that investors should place 10% to 20% in private equity funds, but some people have the risk tolerance and liquidity allowing for higher allocations. However, for other clients, even those with large portfolios, private equity might not be recommended at all. The decision is very individualized.

Investors should narrow the field to a private fund manager who has a strong track record, provides sufficient transparency and has generated returns due to expertise, not luck.

It’s a daunting job for amateurs. Hiring a fee-only investment advisor with a track record of choosing private equity funds can be a smart move.

These funds have higher risk of incurring large losses, or even a complete loss of principal, than do mutual funds, so due diligence is doubly important.

Paul Jacobs, CFP, is the chief investment officer of Palisades Hudson Financial Group. He can be reached at paul@palisadeshudson.com.

Palisades Hudson is a fee-only financial planning firm and investment adviser based in Scarsdale, NY, with $1.3 billion under management and more than 15 years of experience evaluating private equity funds. It offers investment management, estate planning, insurance consulting, retirement planning, cross-border planning, business valuation and appraisal, family-office, and business management, tax preparation, and executive financial planning. Branch offices are in Atlanta, Fort Lauderdale, FL, and Portland, OR. Read the firm’s daily column on personal finance, economics and other topics at http://palisadeshudson.com/current-commentary. Twitter: @palisadeshudson.