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08 December 2021

How Can I Invest in Private Equity?

Private equity is a buzz term for investors. It is an increasingly popular asset class often touted as a vehicle for high returns, though it admittedly comes with higher risks. We look at the ways investors can gain exposure to the trend, how they work, and assess their merits, namely Primary Investment, Secondary Investment, and Direct Co-investment.
 
Primary Investment
Primary investment, or fund of funds (FOFs), is investing in a private markets fund as capital is being raised, which then deploys its capital in a portfolio of primary fund investments. Such a route offers investors access to many private equity (PE) managers and a variety of private companies through a single investment. Naturally, this provides diversification benefits, reducing risk and volatility by minimising the impact of any one investment going wrong. Small investors benefit from being able to access this range of opportunities as it pools their funds, since private markets usually only take large lump sums seriously. FOFs have their own investment teams who perform their own due diligence, which in theory means that the underlying funds should be sound.
 
However, investors invest in private equity to achieve higher returns. Work by Cliffwater research has shown that, net of fees, private equity doesn’t outperform the markets on aggregate. Evidently, some PE funds have performed exceptionally, showing that the asset class can provide best-in-class performance, as long as you invest your money in the right fund. This aggregate figure reveals that there are many underperforming managers. If investing in PE it is all about picking the right investment house, it makes little sense to spread your bets widely with a large group of investment houses you don’t get to choose. It’s better to find a few that you hold conviction in and, as always, understand. In diversified portfolios, PE is usually the aggressive, return-boosting component, and FOFs risk overdiversifying this section from performing its function.
 
FOFs also suffer from higher expense ratios than other funds through two layers of fees – its own fees to pay its team, and the fees of the funds it invests in – which are corrosive to returns. The key argument of diversification is also misleading, as the breadth of funds FOFs invest in make it likely that multiple funds are invested in the same company. This is not necessarily negative, as it counters the over-diversification criticisms, but knowing this information is central to managing risk, and the FOF structure is very opaque, making risk management hard. Opacity is a common criticism of PE, as it gives a stronger focus on ‘star managers’ and allows funds to charge higher fees.
 
Secondary Investments
Secondary investments are where a buyer purchases existing private equity. Sellers are often other PE vehicles looking to reduce exposure to a region or business growth stage, or release liquidity if not ready to fully exit the investment. As these deals enter at a later stage they bear less risk and commensurately lower returns, though these are boosted by the fact that the deal is priced at a discount to its asset value – the seller effectively pays to exit earlier than expected and needs liquidity more than profits. When secondary investments come from other investors looking to reduce exposure, they also mean the buyer will gain less exposure than outright investment, meaning secondary focused funds tend to be more diversified. One of the key advantages of secondary funds is that there is limited ‘blind pool’ risk. This is where primary fund investors must part with their cash before they know what its managers will buy, which obscures predictions of performance and risk.
 
Co-Investment
Lastly, direct co-investments are where PE funds pool together to make an initial investment in a private company, which is then paid in instalments, or ‘funding rounds’. This form of investment yields the most freedom to the fund, which can decide its exposure, craft complex deal structures and reduce risk by taking on other partners. This structure is useful when a PE firm has too many commitments to fully take up an opportunity, but still wishes to do so by bringing in another investor to plug the funding gap. Usually institutions, these investors can also be private individuals. There are more risks to these investors, who are a separate entity, partly due to the fact that they are responsible for analysing and negotiating on their own behalf, while the general partner will charge hidden fees. The main risk comes from the high risk of failure of the individual business since the co-investor has no diversification benefits in this deal.
 
In reality, PE funds are a mix of the three. It is crucial that investors know what they are buying to help understand the risks they face, especially when investing in an inherently riskier asset class. In deciding which mix is most appropriate for you, it is central to our investing philosophy that investment decisions should be made in the context of your personal goals and objectives.
 
This article was taken from the Autumn 2021 issue of 1875. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications.

Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. The value of investments and any income derived from them may go down as well as up and you could get back less than you invested.
How Can I Invest in Private Equity?
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