There has been a democratization of private equity, opening it to investors who previously had a hard time accessing the asset class. Private equity historically has outperformed public markets and offers the opportunity to deliver a significant premium over the S&P 500. However, with more investment choices comes the need for greater scrutiny before committing, especially for investors who are new to the class.
“Some of those who have recently sold their business and have created once-in-a-lifetime liquidity want to put that capital to work by investing in private equity,” says Paul Bodnar, director of investments and private capital and member, at CM Wealth Advisors. “Before they jump in headfirst, there’s considerable research to be done.”
Smart Business spoke with Bodnar about what investors new to private equity, such as those who have recently sold their companies, should consider before committing capital.
How has private equity investing changed?
Private equity and venture funds were exclusive to institutions and ultra-high net worth investors. As the money asset managers could raise from this group started to cap out and word of the return potential sparked broader interest, products were developed that helped bring in a wider range of investors.
Some of these funds are good offerings that help investors access the asset class. Others are less attractive, with some taking advantage of new investors’ lack of knowledge, charging layers of fees for mediocre performance.
While access to the class has increased, some high-quality fund remain reserved for investors capable of signing multi-million-dollar checks. That can create a negative selection bias where the funds accepting lower dollar amounts aren’t as high quality, or they’re an aggregation vehicle that is typically associated with internal fees.
What are some key differences between funds?
There are a range of strategies that could fall under the phrase ‘private equity.’ They can include early-stage venture investments, control buyout transactions of established businesses, and distressed deals that look to turnaround a troubled business.
Within each type of fund, the difference in how and where they invest varies greatly. One group may target businesses with over $100 million in EBITDA and another may be more niche, targeting specialty chemicals businesses that have $5 million to $15 million in EBITDA.
The difference between the top performers and bottom is very wide, unlike public markets where differences are small — often just 100 to 150 basis points separates a top- and bottom-quartile manager. In private markets, a top-quartile private equity buyout fund from 2015 has an Internal Rate of Return (IRR) over 25.5 percent whereas a bottom-quartile private equity fund from the same year has an IRR of 13.9 percent.
The top-performing funds tend to be exclusive and require potential investors to build relationships with fund managers before getting an opportunity to participate, especially in venture. Additionally, those funds are not willing to take small checks, so new investors need a partner that can help.
What should first-time investors consider?
New investors interested in private equity should understand that they cannot get their money out until investments are sold. The illiquid nature also means their investment partner is important as they’ll be tied together for the entire period of the investment, which can be 10 or more years.
It’s critical to cast a wide net. Do not just look at what’s nearby and easy to track down. Spend time on diligence and compare different funds by reviewing historic benchmarks. For example, 20 percent IRR sounds great to a public markets investor, but it’s actually below average for a 2015 vintage fund. Spending time learning the space will pay off over the long run, even if it takes more time to get started.
This is a lot of work, so find a group to work with that has invested in the space. New investors to the class stand to benefit from advisers with deep experience, understanding and access to high-quality funds. ●
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