Think of private equity as a can of Red Bull for your personal portfolio. But there’s a catch: you have to wait 2 to 10 years for the rush to kick in.
Actually, there are several catches, including high entrance costs, complex record-keeping, and a curious mix of volatility (high) and risk (surprisingly low). Private equity isn’t for everyone — at least not yet — but if you’re an alpha-seeking risk-taker who enjoys the thrill of active investing, you too can get in on the party.
And what a party it is: last year, 359 funds raised $246 billion, up 52 percent from the year before and a 39 percent hike from the previous high mark set in 2000, according to Dow Jones’s Private Equity Analyst. Returns tend to average 20 to 25 percent. Moreover, private-equity investments are considered less risky than other high-yield plays, such as hedge funds or junk bonds. The trick is to pick top performers — on average only the top half beat the equities markets.
The main risk private equity poses to investors is illiquidity. “We tell clients not to expect any money back [from private-equity investments] for a long time,” says Bob Morgan, director of private equity for wealth management firm Northern Trust Global Advisors. First-round returns (distributions), which result either from the sale of portfolio companies or from stripping cash out of ongoing operations, don’t begin until 2 to 3 years after the initial pledge of cash. Furthermore, investors are locked into the investment until the fund is ready to close, generally 10 to 15 years from its inception.
If those terms suit you, good opportunities still exist, according to Brent Lipschultz, a personal-wealth specialist for accounting and advisory firm Eisner LLP. What’s more, PE offers diversification (returns tend not to correlate to those offered by stocks and bonds) and the investment is tax-efficient: virtually all gains are classified as long-term and are taxed at 15 percent rather than typically higher ordinary-income rates.
The Price of Admission
There are two ways to join the private-equity elite, with a third on the horizon. Investors can either participate directly or by buying into a fund of funds. Soon they may be able to buy stock in PE firms. In March, private-equity behemoth The Blackstone Group, which manages $28 billion worth of assets, announced plans to take a portion of its portfolio public and list common stock on the New York Stock Exchange. At press time, the date of the initial public offering had not been announced.
Becoming a direct investor is like joining a country club. Investors are welcomed on an invitation-only basis, and the chosen few usually hold some esteemed position or have a relationship with a current partner. Membership is pricey, with minimum investments hovering between $5 million and $10 million. Many funds prefer to limit themselves to a handful of institutional investors that can pony up $50 million to $100 million, in large part because they find that too many small investors can complicate the partnership structure.
Another consideration for the would-be direct investor is that most such investors limit risk by investing in 10, 20, or even 40 funds. That allows them to smooth distributions by laddering investments across time, and to diversify across market segments, explains Nick Vidnovic, director of private equity at Mellon’s Private Wealth Management group. But that strategy requires $50 million to $200 million.
If direct investing seems out of reach, sinking some cash into a fund of funds may be a better bet. Like a closed-end stock mutual fund, a fund of private-equity funds spreads risk over 10 to 30 PE firms. Initial investments start as low as $250,000, and the relatively small amount of cash buys access to many of the exclusive funds that shut out individual investors. That’s because the asset-management companies that run funds of funds aggregate clients’ investments to attract general partners who seek big cash commitments.
Although these collective pools of capital dilute some of the risk associated with private equity, most asset managers limit participants to “qualified” investors, a Securities and Exchange Commission designation that describes an individual with at least $5 million in assets. Most direct funds won’t accept investors unless they are qualified institutional investors, with at least $25 million in assets.
Dabblers Need Not Apply
A fund of funds offers another key advantage: the investment comes with a manager who has expertise handling the notoriously troublesome administrative duties that plague private-equity investors. Unlike securities issued by public companies, PE investments are not made on the day the investor buys into the fund. While the cash commitment is made up front, the money isn’t used until the partnership decides it needs the cash and sends out a “capital call” to investors. Essentially, the general partner of a fund requests additional cash in small chunks, or tranches, only when it spots a deal to pursue. (Private-equity partners aren’t motivated to keep too much cash on hand, because cash buildup hurts the fund’s investment ratios.)
Investors oblige, sending cash to the fund, up to the maximum amount they initially pledged. During the life of an investment, several capital calls are made, sometimes for as little as $50,000, other times for several million dollars. Because the calls are linked to underlying deal activity, they are erratic. General partners have been known to go a full year without calling in investors’ chits, and then to request three tranches in the span of three months. From an investor’s perspective, says Mellon’s Vidnovic, the cash commitments must remain liquid — earning low returns — while awaiting the call.
But dormant cash isn’t the only problem with capital calls. Tracking the transactions, as well as other PE metrics and paperwork, can give even the best accountants migraines. In fact, many experts try to steer clients away from private equity unless they have the wherewithal to pay for administrative help. “If you’re too small to have a family office [an external wealth-management service], you are too small to invest in alternative investments,” declares Jim Schaefer, principal at accounting firm Schaefer & Co., who counts high-net-worth individuals and family offices as clients.
Issuers of publicly traded securities follow rules that mandate timely and tidy financial reporting. That’s not the case with private-equity partnerships. Annual tax information identifying partners’ shares of income (entered on a Schedule K-1) is usually late, and reporting often lags a full quarter. Distributions are as unpredictable as capital calls, and keeping track of both has proved onerous. In fact, investors have been slapped with penalties by PE firms for not meeting capital-call deadlines simply because they had moved and the notices never reached them or they were on vacation and couldn’t be found in time.
As for management fees, they are hefty (1.5 to 2.5 percent of invested capital, which may be assessed annually or on the back end as returns are doled out), but tend not to dissuade investors in their quest for high returns. Put another way, if you have to ask about fees, maybe you can’t afford PE. But if you think there is life left in this market, and you have both the cash and the stomach for a highly volatile investment, there may be a place for you at the clubhouse.
Marie Leone is senior editor at CFO.com.