Considerations When Evaluating Private Equity
When a process is working, standard knowledge suggests leaving it alone. If it is not broken, why fix it?
At our firm, though, we might slightly devote additional energy to making an excellent process great. Instead of resting on our laurels, we now have spent the last few years specializing in our private equity research, not because we’re dissatisfied, but because we imagine even our strengths can develop into stronger.
As an investor, then, what should you look for when considering a private equity investment? Most of the similar things we do when considering it on a consumer’s behalf.
Private Equity 101: Due Diligence Basics
Private equity is, at its most elementary, investments that aren’t listed on a public exchange. Nevertheless, I take advantage of the time period here a bit more specifically. After I talk about private equity, I don’t mean lending money to an entrepreneurial friend or providing different forms of venture capital. The investments I focus on are used to conduct leveraged buyouts, where massive amounts of debt are issued to finance takeovers of companies. Importantly, I’m discussing private equity funds, not direct investments in privately held companies.
Earlier than researching any private equity investment, it is crucial to understand the overall risks concerned with this asset class. Investments in private equity may be illiquid, with traders usually not allowed to make withdrawals from funds throughout the funds’ life spans of 10 years or more. These investments even have higher expenses and a higher risk of incurring giant losses, or even a full lack of principal, than do typical mutual funds. In addition, these investments are sometimes not available to investors unless their net incomes or net worths exceed sure thresholds. Because of those risks, private equity investments should not appropriate for a lot of particular person investors.
For our purchasers who possess the liquidity and risk tolerance to consider private equity investments, the fundamentals of due diligence haven’t changed, and thus the inspiration of our process remains the same. Before we recommend any private equity manager, we dig deeply into the manager’s funding strategy to make positive we understand and are comfortable with it. We need to be sure we are absolutely aware of the particular risks involved, and that we can determine 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 don’t really feel compelled to invest with any particular one. Any questions we’ve should be answered. If a manager offers unacceptable or unclear replies, we move on. As an investor, your first step ought to always be to understand a manager’s strategy and ensure that nothing about it worries you. You’ve got plenty of different choices.
Our firm prefers managers who generate returns by making significant operational improvements to portfolio corporations, relatively than those that depend on leverage. We additionally research and evaluate a manager’s track record. While the choice about whether to take a position shouldn’t be based mostly on past investment returns, neither ought to they be ignored. Quite the opposite, this is among the biggest and most essential items of data a couple of manager that you would be able to simply access.
We additionally consider each fund’s “classic” when evaluating its returns. A fund that started in 2007 or 2008 is likely to have lower returns than a fund that started earlier or later. While the fact that a manager launched earlier funds just earlier than or during a down period for the economy is just not an prompt deal-breaker, take time to understand what the manager realized from that period and how she or he can apply that knowledge in the future.
We look into how managers’ previous fund portfolios were structured and learn how they expect the present fund to be structured, specifically how diversified the portfolio will be. How many portfolio firms does the manager expect to own, for example, and what’s the maximum amount of the portfolio that can be invested in any one firm? A more concentrated portfolio will carry the potential for higher returns, but also more risk. Buyers’ risk tolerances range, but all ought to understand the quantity of risk an funding entails before taking it on. If, for example, a manager has carried out a poor job of establishing portfolios in the past by making massive bets on companies that did not pan out, be skeptical in regards to the likelihood of future success.
As with all investments, probably the most vital factors in evaluating private equity is charges, which can critically impact your long-term returns. Most private equity managers still charge the everyday 2 percent management price and 20 percent carried curiosity (a share of the profits, usually above a specified hurdle rate, that goes to the manager earlier than the remaining profits are divided with buyers), but some could charge more or less. Any manager who costs more had better give a clear justification for the higher fee. We’ve got never invested with a private equity manager who costs more than 20 p.c carried interest. If managers cost less than 20 %, that can clearly make their funds more attractive than typical funds, though, as with the other considerations in this article, charges should not 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 inner controls. While most fund managers will not get a sniff of curiosity from buyers without strong inside controls, some funds can slip by way of the cracks. Watch out for funds that do not provide annual audited financial statements or that can’t clearly answer questions on where they store their cash balances. Be happy to visit the manager’s office and ask for a tour.
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