Considerations When Evaluating Private Equity

When a process is working, typical wisdom suggests leaving it alone. If it isn’t broken, why fix it?

At our firm, although, we’d moderately devote extra energy to making a superb process great. Instead of resting on our laurels, we now have spent the last few years focusing on our private equity research, not because we’re dissatisfied, but because we consider even our strengths can become stronger.

As an investor, then, what must you look for when considering a private equity funding? Many of the same things we do when considering it on a consumer’s behalf.

Private Equity 101: Due Diligence Fundamentals

Private equity is, at its most elementary, investments that are not listed on a public exchange. However, I exploit the time period right here a bit more specifically. Once I talk about private equity, I don’t imply lending money to an entrepreneurial pal or providing different forms of venture capital. The investments I discuss are used to conduct leveraged buyouts, the place massive quantities of debt are issued to finance takeovers of companies. Importantly, I am discussing private equity funds, not direct investments in privately held companies.

Earlier than researching any private equity funding, it is essential to understand the overall risks involved with this asset class. Investments in private equity could be illiquid, with buyers generally not allowed to make withdrawals from funds in the course of the funds’ life spans of 10 years or more. These investments also have higher expenses and a higher risk of incurring massive losses, or even a complete lack of principal, than do typical mutual funds. In addition, these investments are sometimes not available to traders unless their net incomes or net worths exceed sure thresholds. Because of these risks, private equity investments are usually not appropriate for a lot of particular person investors.

For our shoppers who possess the liquidity and risk tolerance to consider private equity investments, the basics of due diligence have not modified, and thus the muse of our process remains the same. Before we advocate any private equity manager, we dig deeply into the manager’s investment strategy to make certain we understand and are comfortable with it. We must be positive we are fully aware of the particular risks concerned, and that we will identify any red flags that require a closer look.

If we see a deal-breaker at any stage of the process, we pull the plug immediately. There are numerous quality managers, so we do not really feel compelled to speculate with any particular one. Any questions we’ve have to be answered. If a manager provides unacceptable or unclear replies, we move on. As an investor, your first step ought to always be to understand a manager’s strategy and make sure that nothing about it worries you. You’ve gotten loads of other choices.

Our firm prefers managers who generate returns by making significant operational improvements to portfolio corporations, reasonably than those that rely on leverage. We additionally research and consider a manager’s track record. While the decision about whether to speculate shouldn’t be primarily based on previous investment returns, neither ought to they be ignored. Quite the opposite, this is among the biggest and most necessary pieces of data a few manager that you may simply access.

We additionally consider each fund’s «vintage» when evaluating its returns. A fund that started in 2007 or 2008 is likely to have decrease returns than a fund that started earlier or later. While the truth that a manager launched previous funds just before or throughout a down period for the economy just isn’t an immediate deal-breaker, take time to understand what the manager learned from that interval and the way she or he can apply that knowledge in the future.

We look into how managers’ earlier fund portfolios have been structured and learn the way they count on the present fund to be structured, specifically how diversified the portfolio will be. What number of portfolio companies does the manager expect to own, for example, and what’s the maximum amount of the portfolio that can be invested in anyone firm? A more concentrated portfolio will carry the potential for higher returns, but in addition more risk. Buyers’ risk tolerances range, but all should understand the amount of risk an investment includes earlier than taking it on. If, for example, a manager has completed a poor job of setting up portfolios in the past by making large bets on firms that did not pan out, be skeptical about the likelihood of future success.

As with all investments, some of the essential factors in evaluating private equity is charges, which can severely impact your long-time period returns. Most private equity managers still charge the everyday 2 p.c management fee and 20 % carried interest (a share of the profits, usually above a specified hurdle rate, that goes to the manager before the remaining profits are divided with traders), however some could cost more or less. Any manager who prices more had better give a clear justification for the higher fee. We have now by no means invested with a private equity manager who costs more than 20 p.c carried interest. If managers cost less than 20 %, that may clearly make their funds more attractive than typical funds, though, as with the other considerations in this article, fees shouldn’t be the only basis of investment decisions.

Take your time. Our process is thorough and deliberate. Make certain that you understand and are comfortable with the fund’s inside controls. While most fund managers will not get a sniff of interest from traders without robust internal controls, some funds can slip by way of the cracks. Watch out for funds that don’t provide annual audited monetary statements or that cannot clearly reply questions on where they store their money balances. Feel free to visit the manager’s office and ask for a tour.

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