Historically, private equity has outperformed public markets and most major asset classes in both short-term and long-term views. At the same time, private equity comes with some unique challenges. A private equity investment is far from liquid and often involves a significant amount of capital.
Until recently, private equity investments were only truly available to institutional investors like university endowments, insurance companies, and pension funds. However, this exciting investment option has become much more accessible in recent years. Because of this accessibility, investors need to exercise caution and do due diligence prior to investing.
Private equity investing is not for everyone, so it is important to understand the challenges and potential of this strategy. Some key questions to ask prior to making a private equity investment include:
Can you handle reduced transparency on performance?
Investors used to public markets come to expect daily reassurance about the performance of investments. The public market makes it very easy to check the daily price quotes and see how the investment is doing compared to similar companies on the market.
People who feel like they need this sort of transparency will not find it with private equity and may do better with other types of investment. Private equity managers report returns and portfolio developments to investors quarterly, but private equity holdings are quite difficult to value. In fact, the value of the investment is often unknown until it is sold.
Can you trust a private equity manager to build value?
The other side of the transparency coin is the fact that private equity investors need to trust their support system. When people invest in private equity, they are trusting managers to create value over a long period of time and the payoff is often not discernable for many years.
This fact makes due diligence incredibly important. Investors should have full faith in their managers. Sometimes, this faith can be a good thing for investors. When people track the daily ups and downs of the market, they can often react based on fear or other emotions rather than thinking logically through the decision.
Are you set up to handle the illiquidity of private equity?
One of the key questions that investors need to ask themselves in relation to private equity has to do with liquidity. Private equity investments are extremely illiquid and notoriously difficult to purchase and sell. Given the long-term nature of these investments, not all investors will be able to handle this illiquidity.
Some approaches to private equity investment do have shorter periods of illiquidity. However, the majority will tie up a considerable amount of capital for at least 10 years, if not longer. Investors who think they will need the cash should look into the public markets, where it is easier to get in and get out without waiting long periods of time.
What do you expect in terms of investment timeline?
Intimately related to the question of illiquidity is investment timeline. Private equity investments often take a decade or longer to mature. Furthermore, identifying good deals in itself takes some time. In other words, once people decide to get involved with private equity, the investment is not always an immediate one.
In general, people who are investing for long-term goals, such as retirement, passing wealth to another generation, or building a philanthropic fund, will typically find private equity attractive. However, people with short-term goals should probably seek different investment opportunities.
Do you understand fund and pricing structures?
Investors may be surprised with the particular fund and pricing structures related to private equity. Examples include the performance fee and the draw down and distribution structure of many private funds.
Before investing in private equity, investors should may sure they understand their financial liability so they do not get caught off guard by unexpected fees or receive less return than they thought. The fine print about fees and expenses is bespoke. This means it is important to go through the details with each investment to get a clear sense of obligation prior to signing.
Where does private equity fit into your portfolio?
Prior to investing in private equity, individuals should have a clear idea about their motivation. Private equity has a number of benefits for portfolios.
For example, the investment can improve diversification outside of public markets and provide potential for higher returns. Some investors turn to private equity for its ability to provide high returns. Others may consider it a counterbalance for publicly traded equities or other assets in a portfolio.
Knowing which goal applies is crucial so investors can identify the right transactions. Working with an advisor is important for figuring out goals, identifying the investment strategies that move toward them, and evaluating whether or not these investments are working.