Considerations When Evaluating Private Equity
At our firm, although, we would rather devote further energy to making a great process great. Instead of resting on our laurels, we have spent the previous couple of years specializing in our private equity research, not because we are dissatisfied, but because we believe even our strengths can change into stronger.
As an investor, then, what should you look for when considering a private equity investment? Lots of the similar things we do when considering it on a client's behalf.
Private Equity 101: Due Diligence Fundamentals
Private equity is, at its most basic, investments that are not listed on a public exchange. Nonetheless, I use the term right here a bit more specifically. Once I talk about private equity, I do not imply lending money to an entrepreneurial good friend or providing different forms of venture capital. The investments I focus on are used to conduct leveraged buyouts, the place giant amounts of debt are issued to finance takeovers of companies. Importantly, I'm discussing private equity funds, not direct investments in privately held companies.
Before researching any private equity investment, it is crucial to understand the overall risks concerned with this asset class. Investments in private equity might be illiquid, with traders typically not allowed to make withdrawals from funds during the funds' life spans of 10 years or more. These investments even have higher bills and a higher risk of incurring large losses, or perhaps a complete loss of principal, than do typical mutual funds. In addition, these investments are sometimes not available to buyers unless their net incomes or net worths exceed certain thresholds. Because of these risks, private equity investments are usually not appropriate for many individual investors.
For our clients who possess the liquidity and risk tolerance to consider private equity investments, the basics of due diligence haven't changed, and thus the muse of our process remains the same. Earlier than we suggest any private equity manager, we dig deeply into the manager's investment strategy to make sure we understand and are comfortable with it. We need to be positive we're absolutely aware of the particular risks involved, and that we are able to 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 various quality managers, so we do not feel compelled to speculate with any particular one. Any questions we've got must be answered. If a manager gives unacceptable or unclear replies, we move on. As an investor, your first step should always be to understand a manager's strategy and be sure that nothing about it worries you. You will have plenty of different choices.
Our firm prefers managers who generate returns by making significant operational improvements to portfolio firms, fairly than those who rely on leverage. We additionally research and consider a manager's track record. While the decision about whether to invest should not be primarily based on previous funding returns, neither ought to they be ignored. On the contrary, this is among the many biggest and most essential pieces of data a few manager that you would be able to simply access.
We also consider each fund's "classic" when evaluating its returns. A fund that began in 2007 or 2008 is likely to have decrease returns than a fund that began earlier or later. While the fact that a manager launched previous funds just earlier than or throughout a down interval for the economy isn't an immediate deal-breaker, take time to understand what the manager discovered from that interval and the way he or she can apply that knowledge in the future.
We look into how managers' earlier fund portfolios have been structured and learn how they count on the present fund to be structured, specifically how diversified the portfolio will be. What number of portfolio companies does the manager anticipate to own, for instance, and what is the most quantity of the portfolio that can be invested in anyone company? A more concentrated portfolio will carry the potential for higher returns, but additionally more risk. Traders' risk tolerances vary, but all ought to understand the quantity of risk an funding entails earlier than taking it on. If, for example, a manager has completed a poor job of establishing portfolios up to now by making massive bets on firms that didn't pan out, be skeptical about the likelihood of future success.
As with all investments, one of the vital important factors in evaluating private equity is fees, which can severely impact your long-time period returns. Most private equity managers still cost the standard 2 p.c administration fee and 20 p.c carried interest (a share of the profits, typically above a specified hurdle rate, that goes to the manager earlier than the remaining profits are divided with buyers), however some might charge more or less. Any manager who costs more had better give a clear justification for the higher fee. We have now never invested with a private equity manager who fees more than 20 % carried interest. If managers cost less than 20 percent, that can clearly make their funds more attractive than typical funds, though, as with the opposite considerations in this article, fees shouldn't be the only foundation of funding decisions.
Take your time. Our process is thorough and deliberate. Make sure that you understand and are comfortable with the fund's inner controls. While most fund managers will not get a sniff of interest from investors without robust internal controls, some funds can slip through the cracks. Watch out for funds that don't provide annual audited financial statements or that cannot clearly reply questions about the place they store their money balances. Be happy to visit the manager's office and ask for a tour.
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