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Understanding private equity investing

There is a convincing argument that advisers and their high-net-worth clients should consider an allocation to private equity

May 27, 2016 @ 11:30 am

By Nick Veronis

The nation's biggest pension fund, the California Public Employees' Retirement System, better known as CalPERS, publicly disclosed last year that it has paid more than $3 billion in performance fees to private equity managers over the past 17 years, while reaping more than $24 billion in profits during the same time frame.

Institutional investors, such as other public pension funds, university endowments, foundations and sovereign wealth funds, have provided similar levels of transparency around the private equity components of their portfolios. This level of detail helps to make a compelling case for why advisers should take the time to better understand the unique characteristics of the asset class, as well as the fees charged by private equity fund managers to investors.

HISTORICAL RETURNS

Private equity firms are focused on delivering outsized returns for their investors and have structured their fees in a way that enables the fund managers to participate in that upside. Private equity has consistently outperformed both public equities and fixed income over the past 20 years, meaning that this profit-sharing arrangement historically has proven to be a critical and worthwhile incentive that helps align the interests of managers and investors. It is important to note, however, that past performance does not guarantee future results. And there are important differences between private equity and public equities and fixed income, including private equity's higher level of risk and illiquidity.

A key element of the private equity model is that the fund managers invest their own money alongside that of their investors, and the managers typically cannot take profits out until their investors have received all of their capital back plus a preferred return. The amount of capital that a manager commits to the fund can vary widely, but is often in the range of 2% to 5%. Sometimes the percentage appears low, but, in the case of a larger fund, the actual dollar amount is significant. The manager commitment is an important factor in evaluating a fund &mdash: you want to make sure the manager is making a personal investment in the fund that is meaningful.

FUND STRUCTURE

Private equity funds are generally structured as limited partnerships. The manager of the fund is called the general partner and the investors that commit capital to the fund are called limited partners. The GP invests the fund's capital, identifies private company investment opportunities, manages the portfolio of investments and determines when to sell portfolio companies. The LPs are passive investors whose capital commitments are drawn down over a fund's investment period and who receive distributions as the fund goes into harvest mode.

INVESTOR ELIGIBILITY

Importantly, investors must qualify to participate in a private equity fund. Most funds require “qualified purchaser” status &mdash: that is, a person with not less than $5 million in investible assets, excluding his or her primary residence, or a company with not less than $25 million of investible assets. Private equity funds typically have stated minimum commitment levels ranging from $5 million to $20 million. These high minimums reflect the fact that private equity historically has been the domain of large, institutional investors.

FEES

Private equity managers charge their investors an annual management fee, typically 1.5% to 2% of the committed capital during the investment period. These fees pay for overhead costs such as investment staff salaries, due diligence expenses, back office and accounting and ongoing portfolio company monitoring. After the investment period, usually the first five years of a fund's operations, management fees are generally charged only against the remaining invested capital. Some managers may also step down the fee from its original rate to a lower rate at that time.

In addition, the fund managers collect performance fees, known as carried interest, which traditionally represent 20% of any value appreciation or aggregated profits generated by the fund.

It is important to point out that in most cases, before a GP can receive carried interest or a share of the fund's profits, the fund must first achieve a minimum rate of return for its investors. This minimum return, also known as the preferred return or “hurdle rate,” is typically 8%. There's an Ivy League endowment chief investment officer who likes to say that as long as a private equity fund is successful in at least achieving the preferred return, his endowment is essentially lending the GP money to operate the fund in the form of the annual 2% management fee.

FUND DISTRIBUTIONS

Distributions from private equity funds follow a waterfall structure. In the first phase of a fund's life, when returns have not yet exceeded the hurdle rate, all distributions are allocated to the investors until they have received all of their money back plus the preferred return. Once a fund achieves its hurdle rate, the GP typically receives a higher share of the profits until the fund manager has caught up to his share of the total profits based on the agreed-upon split, which is typically 80% to investors and 20% to the GP. Once this catch-up has occurred, the remaining profits generated by the fund are distributed, 80% to LPs and 20% to the GP.

CLAWBACKS

It is also worth noting that many PE fund agreements include a clawback provision, which requires the fund manager to hold a portion of the carried interest collected over the life of the fund in escrow to account for scenarios under which the overall performance of the fully liquidated fund dips below the hurdle rate. This allows investors to recapture any excess carried interest that the GP may have retained in order to further ensure that the investors receive their net hurdle rate, assuming of course that the fund's overall returns have met that threshold.

Given the historical outperformance of private equity, the alignment of interests and the preferred return concept, there is a convincing argument for advisers and their high-net-worth clients to consider an allocation to private equity. Private equity offers the possibility of strong performance and may be a valuable addition to a well-diversified portfolio, but it is also illiquid, typically involving a long lockup period, and carries some significant risks that make it appropriate only for certain types of investors. Advisers should learn as much as possible about the mechanics of private equity, as well as the potential benefits and risks, before taking action.

Nick Veronis is co-founder and managing partner of iCapital Network.

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