The Risks And Returns Of Private Equity Investments

Private equity has become an increasingly popular investment vehicle for institutional investors and accredited individuals seeking higher potential returns. However, these investments come with unique risks and complexities that must be carefully evaluated. This article will provide an in-depth look at the world of private equity, exploring its investment strategies, performance benchmarks, portfolio considerations, fund structures, due diligence processes, and future outlook.

Key Takeaways:

• Potential for High Returns: Top quartile PE funds have historically outperformed public markets
• Illiquidity Risk: Investments locked up for 7-10+ years, creating cash flow challenges
• Leverage Impact: Prudent use of leverage can enhance returns but also amplify risks
• Manager Selection: Crucial to identify skilled GPs with strong track records and processes
• Portfolio Fit: PE can improve diversification but allocation levels must be appropriate

What is Private Equity and How Does it Work?

Private equity (PE) is an Alternative Investment it refers to investment firms that directly invest in private companies or conduct buyouts of public companies with the goal of improving their value through operational changes and eventually selling them at a profit. Key attributes of PE include:

• Partnerships structured as closed-end funds with finite lifespans (typically 10 years)
• Capital committed by institutional investors like pensions, endowments, etc
• Investments held through complete acquisition or large minority stakes
• Portfolio companies are actively managed to drive value creation
• Exit strategies of IPOs or strategic sales to realize returns

Types of Private Equity Strategies

The main PE investment strategies include:

1. Leveraged Buyouts (LBOs): Acquiring a controlling stake in an established company, often using significant debt. Improved management and financial engineering aim to increase cash flows to service debt before exiting.
2. Venture Capital: Investments in startups and early-stage companies with high growth potential. VCs provide capital and strategic guidance to founders.
3. Growth Equity: Minority investments in more mature companies seeking capital for expansion, acquisitions, etc.

The Private Equity Investment Process

1. Fundraising: PE firms raise capital commitments from limited partners (LPs) during a formal fundraising cycle for a new fund.
2. Deal Sourcing & Execution: Investment teams source deals, conduct due diligence, value companies, and negotiate investment terms.
3. Value Creation: Post-acquisition, PE firms work closely with portfolio companies to implement operational improvements.
4. Exit: PE firms ultimately look to exit investments through an IPO or sale to strategic or another fund after 3-7 years.

Recommended: How Does Private Equity Work? A Comprehensive Guide

Key Players in Private Equity

• General Partners (GPs): The investment professionals who manage PE funds and make investment decisions.
• Limited Partners (LPs): The institutional investors who commit capital to PE funds as LPs.
• Portfolio Companies: The companies in which PE funds directly invest.

Risks of Private Equity Investing

While private equity offers the potential for higher returns, it carries significant risks that investors must understand.

Illiquidity Risk

Perhaps the biggest challenge of PE is the illiquid nature of the investments. Capital is locked up and cannot be redeemed for 7-10+ years until investments are exited and funds are returned to LPs. This illiquidity makes private equity unsuitable for investors with short-term liquidity needs.

Selection Bias and the J-Curve Effect

Private equity return data can suffer from survivorship bias, as underperforming funds often get brushed aside. There is also an inherent “J-Curve” effect where funds show negative returns early on as fees accrue before investments are exited profitably.

Use of Leverage

Leverage is widely used in PE deals like LBOs to boost returns on equity. However, this amplifies both potential upsides and downside risks if operational improvements fail to materialize as anticipated.

Concentration Risk

PE portfolios can be highly concentrated in relatively few investments compared to diversified public market funds. This concentrates both risks and rewards in each deal’s outcome.

Agency Risks

The differing interests of GPs (generating returns) and LPs (preserving capital) can create principal-agent conflicts. Misalignment of incentives is an inherent risk.

High Investment Minimums

Most PE funds require very high minimum capital commitments, often $10M+. This creates a high barrier to entry for all but the largest institutional investors.

Market Risk for VC & Growth Investments

While LBOs of established companies have some defensive qualities, VC and growth equity investments in startups carry significant market and execution risk.

Default Risk vs Public Equity

LBO transactions using high leverage increase default risk compared to public companies. This can lead to a total loss of invested capital in the worst cases.

Comparing Private Equity Returns to Other Asset Classes

Benchmarking Private Equity Performance

There are inherent challenges in directly comparing private equity performance to public market equivalents like stocks and bonds. PE returns are irregular, funds are not marked-to-market, and valuations can be smoothed. However, studies by Cambridge Associates and others provide insights into how PE has performed historically.

Private Equity vs Public Equities

From 1986-2021, US private equity funds returned a pooled net internal rate of return (IRR) of 13.7% compared to 10.7% for the S&P 500 over the same period. Top quartile PE funds averaged a 21.5% net IRR versus 17.5% for public equities.

Private Equity vs Public Debt

For the 2000-2021 period, buyout funds returned a 12.6% pooled IRR compared to just 4.2% for the Barclays Capital Govt/Credit Bond Index. Venture capital funds averaged even higher returns of 21.5% over that span.

Private Equity Performance by Vintage Year

Historical private equity returns have exhibited significant cyclicality and variance by vintage year when funds were raised:

• Funds raised pre-2005 generally underperformed public market equivalents
• Funds from 2005-2008 leveraged cheap debt to generate very strong returns
• The 2008-2012 vintages lagged public markets following the financial crisis
• More recent 2013-2019 vintages benefitted from rising asset valuations

Key Factors Impacting Private Equity Fund Returns

• Entry valuations paid for acquisitions and use of leverage
• Ability to implement operational improvements and create value post-acquisition
• Sector focus, macro exposures, and economic factors impacting portfolio companies
• Exit environment and valuations prevailing when investments are exited
• Competitive dynamics and pricing when funds are raised, impact deployment

Valuation Challenges for Private Equity

Unlike publicly traded stocks, private equity fund holdings are not regularly marked to market in real-time. This can lead to some return smoothing effects. However, standardized guidelines like International Private Equity Valuation (IPEV) help provide more uniform fair value estimates.

While private equity has generated higher returns on average compared to public markets historically, returns can vary significantly based on the vintage year, specific strategy, sector, and individual fund managers selected. Prudent investors must diligently assess their private equity exposure as part of an overall diversified portfolio strategy.

Asset Allocation Considerations for Private Equity

Also See: What is Private Equity? A Thorough Guide to Understanding This Alternative Investment

Why Illiquidity Matters for Asset Allocation

The extended lockup periods and illiquidity of private equity investments has major portfolio management implications. Investors must carefully assess their long-term cash flow needs and liquidity requirements before allocating to these illiquid assets.

Impact of High Transaction Costs

Due to their labor-intensive nature, private equity funds charge relatively high fee loads compared to public market investments. This cash drag from fees can reduce the overall net returns achieved in investor portfolios.

Role of Private Equity in Diversified Portfolios

Despite the risks, an allocation to private equity can potentially improve overall portfolio diversification for investors due to its lower correlated returns versus public equities. Its illiquidity premium and ability to boost returns can also help meet long-term goals.

Optimal Private Equity Allocation Levels

The appropriate private equity allocation varies based on an investor’s specific return targets, risk tolerances, and liquidity constraints. However, some general guidance for diversified portfolios includes:

• Pensions/endowments: 10-30% in PE
• High net worth: Up to 20% in PE
• Individual investors: 5-10% maximum, if cash flows allow

The Illiquidity Premium Debate

A key consideration is whether the historical outperformance of private equity is merely compensation for the illiquid nature of the asset class or if PE managers are genuinely able to generate alpha by sourcing and improving companies.

The illiquidity premium theory posits that investors should demand a higher expected return for giving up liquidity in their portfolio for an extended period. This premium would explain PE’s excess returns over public markets.

However, research by professors like Steven Kaplan at the University of Chicago suggests PE’s outperformance may be more attributed to skilled managers and their ability to create operational value at portfolio companies:

• GPs focus deeply on a narrower set of investments, allowing more oversight
• They take more controlling positions to drive key initiatives like cost-cutting
• Financial engineering from leverage boosts equity returns
• Industry expertise helps source proprietary deals and guidance

So while the illiquidity premium likely plays some role, there seems to be an element of manager “alpha” that persists even after adjusting for factors like illiquidity, leverage, and fee loads.

From an asset allocation perspective, investors should likely view allocations to top private equity managers as having both “beta” exposure to the illiquidity premium and the potential for excess alpha generation. This can help justify the higher fees, illiquidity, and risks associated with the asset class.

Ultimately, skilled manager selection and portfolio fit remain crucial considerations when allocating to PE. The illiquidity premium alone is likely insufficient justification, especially for investments with below-average managers lacking differentiated capabilities.

Private Equity Fund Structures & Fees

The LP/GP Model and Fund Dynamics

The predominant private equity model involves fund managers (GPs) raising capital commitments from institutional investors (LPs) into closed-end fund structures with 10+ year life cycles:

• LPs commit a fixed amount of capital upfront that is drawn down over time
• GPs make investment and exit decisions, actively managing portfolio companies
• Primary incentives are the annual management fees and carried interest splits

The inherent complexity of this LP/GP model with misaligned incentives between principals (LPs) and agents (GPs) is an important dynamic influencing fee structure.

Fee Types in Private Equity Funds

The main types of fees charged by PE funds include:

• Management Fees: Annual fees of ~2% of committed capital, meant to cover staffing, investment sourcing, and fund operations. Represents a cash drag on performance.
• Carried Interest (“Carry”): The GP’s cut of any profits generated, typically 20% above a minimum hurdle rate. Incentivizes generating returns but can create conflicts of interest.
• Transaction Fees: Charges for sourcing, executing, and monitoring investments. Help defray the monitoring burden but can double-dip with management fees.

Transparency and Reporting Challenges

The lack of third-party pricing sources and appraisers for private assets creates valuation subjectivity. Historically, PE funds have provided minimal transparency to LPs regarding costs and fee calculations.

However, recent initiatives like the Institutional Limited Partners Association (ILPA) Principles are pushing for improved fee calculation standards and more detailed reporting to LPs.

Aligning GP/LP Interests Through Incentives

Given the potential conflicts, PE fund documents aim to create incentives that better align GP/LP interests:

• Requiring GPs to co-invest their own capital in deals alongside LPs
• Implementing European-style waterfall distributions prioritizing LP returns
• LPs receiving preferred returns to clear hurdle rates first
• LPs able to review and reject various GP compensation streams
• Requirements for annual audits and due diligence by LPs

Overall, while the fee loads can be high, the goal is to ensure sufficient incentives are in place to maximize returns for both the GP and LP investors.

Due Diligence & Manager Selection for Private Equity

The Importance of Thorough Due Diligence

Perhaps one of the most critical aspects of successful private equity investing is rigorously evaluating and selecting the right fund managers as partners. This operational due diligence process on GPs allows LPs to:

• Assess the skill, expertise, and decision-making of the investment team
• Evaluate past performance data and investment process
• Identify any operational risks or issues with the management firm
• Understand the strategy and sectors the fund will focus on
• Gauge interests are properly aligned through compensation structures

Institutional investors often dedicate substantial internal resources and leverage third-party consultants to conduct GP due diligence before commitments.

Evaluating a Manager’s Track Record

A key part of due diligence involves scrutinizing a manager’s prior funds and track record:

• Assessing each fund’s net returns, risks, and consistency of performance
• Identifying any performance degradation across successive funds
• Understanding what drove the successes/failures of prior investments
• Looking for skill differentials versus just riding market tailwinds
• Analyzing underlying portfolio company operational improvements

Assessing Investment Strategy and Process

In addition to past returns, investors need to evaluate the repeatability and differentiation of a GP’s strategy going forward:

• Does the firm have unique sourcing capabilities or partnerships?
• How are deals sourced, evaluated, and value creation plans developed?
• How involved are investment professionals in portfolio oversight?
• Are there checklists and processes in place to drive consistency?
• What changes are anticipated to the new fund’s approach? Reasonability?

Operational Due Diligence Review

LPs conduct operational reviews of PE management firms, examining:

• Organizational structure, culture, team dynamics, incentives
• Back-office processes, controls, compliance, and reporting capabilities
• Fund accounting, valuations, cash flow forecasting, and LP communications
• Use of third-party administrators, auditors, custodians, and IT systems
• Historical issues, conflicts, lawsuits, or regulatory infractions

Any potential red flags can highlight operational risks that could impair future performance.

The Role of Co-investments

Some LPs may also have the opportunity to make co-investments directly into specific deals alongside the PE fund. This further enhances governance and allows even closer monitoring of the GP’s practices and investment process first-hand.

Overall, the due diligence process requires extensive resources, striking the right balance between adequate scrutiny while being efficiency. But it remains a crucial part of separating skilled managers from the rest.

The Future of Private Equity

Industry Growth and Rising Competition

The private equity asset class has experienced rapid growth over the last two decades, with global assets under management swelling from under $1 trillion in 2000 to over $7.5 trillion today as of 2023. Strong historical returns led to increased allocations and new entrants seeking a share of the profits.

However, with growing AUM and competition for the same deals, concerns have arisen over whether too much money is chasing too few quality companies. PE fund sizes continue scaling up, with many multibillion-dollar megafunds now in the market. This raises questions over whether large funds can effectively deploy such massive amounts of capital prudently.

Downward Fee Pressure Building

As PE has grown more mainstream, limited partners have gained increased negotiating leverage to push for lower fees and more favorable fund terms. Some of the most prominent recent trends include:

• Lowering annual management fee percentages closer to 1% of committed capital
• Seeking lower performance hurdle rates that must clear
• Demanding larger GP commitments to increase alignment
• Increased use of newly raised funds to finance the GP commitment
• Requiring rebates or revenue shares from certain fee streams

At the same time, rising costs of hiring top talent and resourcing investment capabilities remain a challenge for firms. This fees-versus-expenses tension will likely remain an ongoing source of negotiation.

Emergence of New Models and Direct Investing

As many investors have gained experience in PE, some have looked to gain further control and cut out third-party fund fees by investing directly into deals themselves. This can potentially boost net returns but requires building out extensive in-house investment teams.

New models are also emerging in private equity, such as longer-duration “permanent capital vehicles” that don’t face the same exit timing pressures as closed-end funds. There has also been a growth of secondary funds that acquire existing PE fund stakes from LPs looking to rebalance their portfolios.

Potential Regulatory Changes Ahead

Currently, most PE funds only accept capital from accredited investors or institutions due to lighter disclosure requirements. However, there are ongoing regulatory discussions around potentially easing some of these requirements to allow broader retail investor access.

Other potential regulatory impacts involve tax policies like the proposed ending of the preferentially carried interest loophole that taxes PE performance fees at lower capital gains rates. The SEC has also proposed stricter transparency rules on fees, expenses, and performance reporting required for PE funds.

New Opportunities and Growth Areas

Despite increased competition, fund managers continue to identify new opportunity sets to explore, including:

• Greater investments in real asset funds focused on areas like infrastructure, energy, and real estate
• Growing interest in impact investing, ESG integration, and socially responsible investing mandates

Real Assets and Alternative Sectors

As institutional investors seek further diversification from traditional asset classes, many are increasing allocations to real assets and other alternatives like:

• Infrastructure funds acquiring toll roads, utilities, airports, and other core assets
• Energy funds focused on oil/gas exploration, renewable power generation, midstream assets
• Real estate funds invest across property sectors like multi-family, office, industrial, etc.
• Agriculture/timberland funds acquiring farmland, plantations, and other natural resources

These types of real asset investments can provide diversification from public equities while also generating income. They also offer more defensive recession-resistant qualities compared to traditional PE.

Impact Investing and ESG Considerations

There has been a groundswell of interest from investors wanting their capital to not only generate returns but also drive positive environmental and social impact. This has led to an emergence of impact-focused investment strategies such as:

• Sustainable food/agriculture investing in improved farming practices
• Renewable energy deployment funds for solar, wind, and clean technologies
• Affordable housing, community development, and urban revitalization funds
• Diversity-lens funds targeting minority entrepreneurs and overlooked areas
• Socially responsible buyout funds focused on governance, environmental, and other ESG factors

As investors increasingly focus on ESG issues, even traditional PE funds have been pressured to enhance their responsible investing policies and reporting around factors like climate change, labor practices, board diversity, and data privacy.

Emerging Market Growth

While the bulk of PE capital has been concentrated in the U.S. and other developed Western markets historically, there is growing GP interest in untapped opportunities across emerging economies:

• Funds targeting investments in fast-growing markets like India, China, and Southeast Asia
• A focus on sectors like technology, consumer, and healthcare assets benefitting from rising incomes
• Potential for higher returns given relatively lower entry valuations and operational improvement opportunities
• However, additional political, currency, and execution risks must be navigated carefully

As private equity markets continue maturing, the ability of fund managers to continuously identify compelling new investment themes and remain adaptable will be critical to driving future performance.

Drawbacks of Private Equity Investing

While the potential for higher returns makes private equity alluring, it’s important for investors to thoroughly understand and weigh the significant drawbacks carefully.

Higher Risk Profile Than Public Markets

Private equity investing is inherently riskier than public stock and bond investments in several key ways:

• Lack of daily pricing, liquidity, and mark-to-market valuation creates greater uncertainty
• Funds use high levels of debt leverage that can amplify losses if investments sour
• There is the high company and deal risk due to concentrated portfolios lacking diversification -Irmature companies face more operational, competitive, and market disruption threats
• The due diligence process is more subjective and can overlook potential issues

For any individual PE fund, there is a much wider range of potential outcomes from a complete loss to outsized gains compared to public market equivalents.

Substantial Illiquidity Constraints

The largest drawback may be the extensive lockup periods and lack of liquidity. Typically investors’ committed capital gets drawn down gradually and then remains inaccessible for a decade or more until investments can be fully realized and funds returned.

This illiquid nature creates major cashflow planning challenges for investors with near-term liquidity needs. It also serves as a key reason why many individual investors are restricted from accessing PE funds at all due to their limited resources.

Complexity of Managing Private Assets

Managing a portfolio of private assets is inherently more complex than public securities:

• Lack of uniform reporting standards across holdings
• Difficulty obtaining timely and accurate updates on company operations
• No exchange listing or publicly available pricing
• Reliance on GP’s fair value marks and related conflicts of interest
• Tax complexities from deal structuring and mix of asset types held

These difficulties create additional operational burdens and major disparities in transparency versus public holdings for investors.

Extended Investment Lock-up Periods

Not only must PE investors commit capital for a 10-12-year fund lifecycle initially, but they may face additional extensions if funds decide to hold investments and refinance assets rather than exiting them on their originally contemplated schedule. These potential extensions can further exacerbate illiquidity for limited partners.

Overall, while private equity offers compelling potential benefits, investors must have the resources, risk tolerance, and patience to navigate the various drawbacks and difficulties involved. A prudent allocation strategy with reasonable expectations is crucial.

Conclusion

Investing in private equity can provide opportunities to enhance portfolio returns over the long run, but navigating the risks and unique characteristics of the asset class is crucial. Key points to consider include:

• While PE has historically outperformed public markets on average, returns can vary significantly based on economic cycles, leverage, manager skill, and vintage year funds were raised.
• Illiquid investment horizons spanning 7-10+ years require careful cash flow planning and introduce substantial risks. High fees can also erode net returns versus public markets.
• Sound asset allocation is paramount, with PE more suitable for institutional or accredited investors able to prudently limit allocations within proper portfolio constraints.
• Rigorous due diligence capabilities are required to evaluate and select skilled investment managers who can successfully navigate the highly complex nature of these investments.

Given its risks, most advisors recommend only allocating to PE if it represents a relatively small portion of an investor’s broader diversified portfolio. But for those with the risk tolerance and proper guidance, exposure can provide a valuable potential return enhancement over the long term.