Money Management Executive
Private-equity investments have been making headlines lately and seem to be where the smart money wants to go.
Private-equity investing has been limited to the ultra-wealthy, but the large returns generated by some funds are piquing the interest of others who'd not traditionally have been candidates for such vehicles.
Moreover, there's good reason to expect that the barriers to entry are getting lower, allowing retail investors to venture into venture capital — though at a lower rate of return than their wealthier counterparts.
According to a survey completed earlier this year by U.S. Trust (now U.S. Trust, Bank of America Private Wealth Management), wealthy investors are increasingly interested in alternative investments, including private equity. On average, more than half of the investors — all of whom had a minimum of $5 million of investable assets — had 8% of their portfolio dedicated to private equity, the survey found.
Of those holding private-equity positions, 63% said these investments play a "significant" or "very significant" role in generating wealth, and 27% said they intended to increase their holding.
Private-equity investment in the United States has risen steadily since the 1980s. In 1980, U.S. private equity funds held $5 billion. Since then well over $1 trillion has passed through private-equity funds. Last year 222 funds raised $30.9 billion.
The surge in private equity partly reflects the historic returns these funds have offered. According to Thomson Financial and the National Venture Capital Association, private-equity funds have outperformed the Standard & Poor's 500 index and the Nasdaq of late. In the past three years venture funds have returned 9.6%, versus 8.1% from the S&P 500 and 6.7% from the Nasdaq.
Investors in private equity are almost by definition ultra-wealthy individuals, because the Securities and Exchange Commission allows only "qualified investors" to purchase such securities. Clients must have a net worth of $1 million or an annual salary of $200,000 or more for the past two years ($300,000 for a married couple).
Few investors can afford to invest in private equity. Many of these investment opportunities come with minimum contributions of millions of dollars and frequently require the money remain invested for up to five or seven years.
Thomas Payne, a managing director of Harris MyCFO, the wealth management arm of Bank of Montreal's Harris Bank, says private equity should play a minor role in most portfolios and must be money the investor can afford to lose.
But, there's evidence some private-equity funds are moving down market, and observers expect to see opportunities arising over the next few years that will create more affordable entry into private equity.
Private equity mainly comes in three flavors: direct placement of money in a business; investment in a fund that makes such placements (typically in a single sector of the economy); and investment in a fund of funds, made up of a basket of sector-specific funds.
In all cases, investors have less information than they would receive from SEC-registered companies. Performing due diligence on private-equity investments is difficult, which is one reason the SEC restricts who can purchase them.
Each investment requires trade-offs. Direct placements are the most difficult to make successfully, but offer the highest potential return if the company succeeds. They are also the most risky, as they tie the amount invested to the fate of the company that receives the money.
The expected annual return for a good direct placement is in the neighborhood of 30% to 40%, but the wrong choice can result in large losses. Few advisers will have the connections to bring their clients into direct contact with potential investment targets, but there are ways to get clients exposure to private equity. Most large private-equity players have funds that are open to wealthy investors.
While a fund has the advantage of spreading the risk across several companies, it also has a downside. Private-equity fund managers are lavishly paid. They typically take an annual fee of 2% of all assets under management and 20% of profits.
This can crimp the returns these funds generate. A study published in The Journal of Finance in 2005 found that after fees, the average private-equity fund returned little more than the S&P 500.
Most private-equity funds are also sector-specific, either in terms of the lines of business they invest in or to the type of investing they do, and retain some concentration risk.
The third option for private-equity, the fund of funds, presents the greatest opportunity for diversification, but there's an additional layer of management fees. On top of the built-in fees of the private-equity fund managers, investors pay a fee to the fund of funds' manager.
The fund-of-funds approach has been gaining popularity. According to Dow Jones, from 1996 to 2005 the money in funds of funds grew tenfold, to $13.9 billion. An alternative to the fund-of-funds approach is the private-equity exchange-traded fund, but ETFs don't typically have enough history to report detailed performance over time.
