Invest Carefully in Private Equity Funds

recent newspaper article discussed how private equity investments are "taking Wall Street by storm" and how it is easier now for individual investors to "get a piece of the action", once reserved only for institutions and the super wealthy. Let's explore why most investors should not rush to invest.

As background, private equity refers to the practice of investing in and buying companies that are not publicly traded but instead are privately owned. These companies range from being start-ups to mature companies, and typically seek financing from private equity funds to fund an acquisition, to grow, to develop products or for other business purposes designed to generate more company profits.

As a group, private equity funds have posted strong returns, indeed significantly better than major stock indices during some periods. But for investors, there are three main concerns. First, returns among private equity funds vary widely and, indeed, are difficult to measure in any event. Second, private equity investments lack liquidity and marketability. Third, private equity funds charge investors significant fees. Let's explore these shortcomings.

In terms of returns, it is difficult to measure returns (which vary widely when measured) for two reasons. First, many private equity funds are too young to even make a valid measurement. Second, even mature funds begin anew, in a sense, when they start a new investment cycle by choosing a new company in which to invest.

Moreover, advisers agree that investors must give private equity funds about ten or more years to determine returns. Traditionally, here is how the "cash flow dynamics" of private equity investments work. Upfront, investors make a commitment to invest. Next, the private equity fund managers make investments in privately held companies. This is called the "vintage year." From this point, and on a continuing basis, investors make a commitment to invest money by way of "capital calls." Investors should know that they may be called upon to commit additional capital frequently and with little notice. As a result, investors normally experience negative returns through the first 8 years or so of their investment, or if fortunate, they break even. After about 10 year or more, distributions (return) to investors will occur as the fund's underlying investments (the companies invested in) are sold.

The prospect of capital calls may be avoided in Wall Street's "retail" version of private equity fund investing. That is, like funds of hedge funds, investors now can purchase funds of private equity funds. For example, Lehman Brothers Holdings, Morgan Stanley and Charles Schwab (through U.S. Trust) all offer funds of private equity funds which require relatively low minimum investments - from $100,000 to $500,000.

The second concern is lack of liquidity and marketability. Whether invested in a traditional private equity fund or a new fund of private equity funds, investors often are required to commit to a 10 year time period. Should an investor wish to exit the fund early, he or she may forfeit a large part of the investment.

The third concern is the hefty fees. In a traditional private equity fund, investors should expect to pay not only an asset-based fee of 1.5% to 3%, but also 20% to 35% of profits. In the event that the investor purchases a fund of private equity funds, he or she should add to those fees an additional 1% asset based fee and another 5% of the fund's profits. Some private equity funds and funds of private equity funds, however, do not charge the profit-based fee until after the investors receive some minimum rate of return, typically about 8% annually.

Finally, as with all private placements, the securities laws require that investors meet certain income and net worth requirements. More selective private equity funds and funds of private equity funds typically only admit investors with substantial net worth. Investors nonetheless should limit their private equity investments to a small portion of their total investment portfolio, perhaps 2% to 5%. Even then, advisers recommend that investors diversify their private equity investments across different industries.

Though popular and available, investors must guard against taking on too much risk through investing in private equity funds, given their wide disparity of returns and difficulty in measurement, lack of liquidity and substantial fees. Advisers who recommend such investments are required to determine that, all things considered, they are suitable for the particular investor.

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James J. Eccleston is a securities attorney, representing customers as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston, and can be reached at 312-621-4400.