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.