With the volatility of the stock and bond markets, wealth management firms are often asked about other options for a portion of a portfolio. A common one is private equity. Before considering it, it is important to understand this type of investment.
Private equity is an alternative asset class in which companies can raise funds outside of the public markets. It includes different fund strategies, the most fundamental being private equity (PE) and venture capital (VC) funds. PE funds buy mature companies and look to make them more profitable by improving their management, business strategy and operations. Investing in established companies comes with a lower risk of failures. PE funds usually buy a majority stake in a private company but can also purchase public companies and take them private. These investments occur through a management buyout, involving the purchase of equity, or a leveraged buyout.
VC funds primarily invest in startups with significant perceived growth possibilities. They offer a higher potential return than traditional investments, but tome with higher risk. Even so, investors in venture capital typically have the kind of wealth where they have most of their money in lower-risk investments and devote a small percentage of their portfolios to higher-risk venture capital.
Capital committed vs. capital called
Capital committed is the total amount of capital commitments made by limited partners into a fund. Capital committed to a fund typically sits in a liquid account until the general partner finds a new investment and makes a “capital call” to limited partners to pay for it. A capital call is for a percentage of the capital each limited partner has committed. They typically happen in the first three to five years of a fund’s life.
There are several ways to invest in private equity. You can invest directly into underlying companies, or in a single PE or VC fund. Both carry high levels of risk and may require large allocations to attain an appropriate amount of diversification in your private equity portfolio. Another way is investing in a fund of funds, which invests in a range of PE or VC funds. This offers instant diversification of underlying fund manager performance, strategies, geographies and vintage years.
These multi-manager funds are run by professional managers at firms that access highly sought-after PE and VC fund managers. Research suggests that top-ranked funds have outperformed bottom-ranked funds by an average internal rate of return of 25 percent for the last 20 years.
PE or VC firms typically have a 10-year term plus a year or two of extension to allow general partners time to spot attractive investments, grow the businesses and time exits with favorable market conditions. However, the average time before limited partners get invested capital back is typically closer to seven or eight years because portfolio companies will be sold at various points of a fund’s life.
When you invest in private equity strategies, you are expected to wait the requisite time before getting a return. PE and VC funds are illiquid because of the long-term investment horizon and nature of the underlying companies. ●
Ronald Ambrogio is Regional President – Ohio at BNY Mellon Wealth Management