PRIVATE EQUITY INCREASINGLY POPULAR ALTERNATIVE TO MUTUAL FUNDS AND STOCKS
Once the domain of institutions and the wealthiest of investors, a sophisticated alternative form of investing known as private equity is trickling down to less affluent investors. Although the current market has taken some of the steam out of this increasingly popular form of investing, qualified investors may want to consider adding this asset class to their more traditional portfolios of stocks, bonds and mutual funds.
As the name implies, private equity involves the purchase of equity in privately held companies, varying from high tech and cutting-edge medical firms to retail stores and money management firms. The three main versions of this asset class are buyout funds, venture capital funds and mezzanine financing.
Buyout funds—current-day versions of the old leveraged buyout firms—specialize in buying established companies, often family owned, or spun-off divisions of large companies. Venture capital funds finance the start or expansion of new companies, often specializing in a single field such as telecommunications and in a single region of the country. Buyouts and venture capital funds make up the vast bulk of the private equity market. A third form, mezzanine funding, is the financing of leveraged buyouts or other debt financing, often in middle-market companies. Once limited to domestic funds, the private equity market has spread globally.
These three variations on private equity come in one of two forms. At what might be called the grassroots level is the private equity fund, which is basically a limited partnership with a general partner and up to 499 “qualified purchasers.” By law, individual limited partners in these funds must have at least $5 million in investable assets, and some of the funds require investment minimums well above that. The high minimum, and a high demand, has made these funds difficult to get into even for many wealthy investors.
That’s changed with the emergence of funds of funds. These funds require minimums more in the range of $250,000 to $500,000, opening up private equity to less wealthy investors. These funds buy into multiple underlying private equity funds, thus diversifying individual investments. Some funds focus on only a type of private equity fund, such as venture capital funds, while others cut across categories. Another advantage of funds of funds is that they do
the research. It’s difficult for the individual investor to get solid performance information on private equity funds, let alone access.
The major drawback with funds of funds, according to experts, is the added layer of fees. An underlying private equity fund charges management fees of 1.5 to 2.5 percent and 20 to 30 percent for what’s called carried interest, which is a share of the profits. A fund of funds adds an annual fee plus a small carried interest charge, and for that reason, some CERTIFIED FINANCIAL PLANNER™ (CFP) professionals don’t recommend these funds.
Don’t confuse the word “fund” with mutual funds. Whether you invest at the ground level in a private equity fund or a fund of funds, you are investing in a highly illiquid asset, though a secondary market is developing. Typically, your commitment is three to five years. These funds also are more volatile than your plain-vanilla mutual fund. While the performance difference between a top quartile mutual fund and the bottom quartile might run 10 to 12 percent, the difference among buyout and venture capital funds might run 20 to 30 percent or more.
Is it worth the extra expense and risk? In the case of venture capital funds, annualized three-year returns, ending September 30, 2001, were a staggering 90.5 percent, despite a terrible 2001, according to Cambridge Associates’ U.S. Venture Capital Index. Five-year returns were 54.1 percent. These returns are net of fees, expenses and carried interest. Returns are less impressive for Cambridge’s Private Equity index, a proxy for buyout funds. In 1999, annualized five-year returns were 23.9 percent, but in 2001, five-year returns had fallen to 11.2 percent and three-year returns were only 5.8 percent.
Proponents also argue that not only does private equity offer the prospect of higher returns, the asset class is not highly correlated with bonds or publicly traded stocks (though there is some debate about this). Still, the commitment generally should be small, say CFP professionals who have clients in private equity. They generally recommend that the asset class represent only a small percentage of the investor’s overall portfolio—perhaps five to ten percent.
February
2002— This column is produced by the Financial Planning Association, the
membership organization for the financial planning community, and is provided
by Rich Chambers, CFP™, a local member in
good standing of the FPA.
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