One of the first private equity deals to capture my attention, as an analyst, was the buyout of high-fashion women’s shoemaker Jimmy Choo. The deal, like the product of the company, was just plain sexy: In 2001, Phoenix Equity Partners purchased a GBP 9 million, 51-percent stake from Jimmy Choo (the co-founder of the company), and then sold it for five times as much to Lion Capital, another private equity firm, in 2004.1
Over the past decade, the high-fashion brand has changed hands, going from yet another private equity firm to a family-owned private company. In 2014, Jimmy Choo went public at a valuation of GBP 547.5 million.2 If you run some back-of-the-envelope numbers, the company increased in value 30 times, or at a 27-percent compounded annual rate, over 14 years.
Those are some pretty impressive numbers, and there are similar, exciting stories of private equity deals that circulate at cocktail parties. However, the stories that are told with less zeal are those of private equity investments that perform poorly. Nobody — neither the private equity fund manager, nor the private equity investor — wants to brag about the deal they lost.
There is a wide dispersion of returns among private equity managers, and the best-performing managers (i.e., the top quartile, or top 25 percent) tend to have returns that are substantially better than the rest of the pack. One explanation for this dispersion is that private equity is an inefficient asset class and offers opportunities for experienced private equity managers — who are adept at finding the right companies — to create substantial value.
How, exactly, is this value created? It can take several forms, such as operational improvements, defining and implementing strategic growth plans, or better aligning management interests with shareholders, to name a few. If you decide to be in the private equity space, investing with top-quartile private equity managers can provide the potential for higher expected returns.
Aside from potential return enhancement, which is what draws most investors to the space, there are many factors to consider before embarking on a private equity investment program:
1. Asset Level
Private equity investments are generally only available to qualified purchasers (i.e., investors with $5 million or more in investable assets). If you are a qualified purchaser, keep in mind that private equity funds also have high-minimum investment requirements, ranging from $250,000 on the low-end to as high as $10 million.
High-quality, private equity fund managers can institute these minimums, because they are highly sought-after and can still raise the capital they need, even with these high minimums. Given these minimum investment requirements, an investor would need a substantial pool of assets to devote to this space in order to achieve appropriate diversification within a private equity portfolio. Globally diversified public equities should be the cornerstone of the equity portion of most investors’ portfolios. An investment in private equity can be considered only after this component is in place.
2. Long Investment Horizon
Compared to public equities, private equity investments are illiquid and typically have a 10-year investment horizon. This investment period can be stretched further in difficult market cycles, when private equity managers may have fewer exit options.
If you are considering private equity, you must bear in mind that the capital will be tied up for several years, so you should not deploy funds that you may need in the near-term.
3. Less Diversification
Private equity fund investments are concentrated; a typical private equity fund will have 10 to 20 portfolio companies per fund. This level of concentration means that there is more idiosyncratic risk, or risk that a single company failure will heavily impact the overall fund return. High-minimum investment amounts can also make it difficult to diversify across multiple funds.
To overcome the hurdles to diversification, you have the option of using a private equity fund-of-funds vehicle. A fund of funds provides access to multiple private equity manager funds within one vehicle. There are additional fees associated with a fund of funds; however, the benefits, which include professional manager selection, access to top-quality managers and diversification, can be worth the incremental cost.
Private equity fund fees include a management fee component (generally ranging from 1.5 percent to 2 percent of the commitment amount) and a share of the total profits, or “carried interest,” which is typically 20 percent of the profits.
These fees are high when compared to public equity managers.
In order to have a successful investment experience after fees, it can be critical to be invested with high-quality managers. Top-quartile managers are highly sought-after, and gaining access to these funds can actually be more challenging than identifying the top-quality managers — particularly for individual investors, who are in a space that is often dominated by large pension funds and sovereign wealth funds.
Access is another area where fund-of-funds managers, who often have established relationships with successful private equity managers, can provide a good solution.
5. Vintage Year
Private equity funds are often categorized by the year in which they were raised; this is referred to as the “vintage year”. Similar to public equity, private equity is subject to market cycles. Funds of a certain vintage year may offer the benefit of investing when valuations are low, and the ability to ride the market cycle and sell when valuations are high. Returns can vary a great deal, depending on a fund’s vintage year.
When allocating to private equity, this underscores the need for diversification not only by manager or strategy type, but also by vintage year, since it can be difficult to predict the market environment.
Private equity is a complex space, and these are just a few of the key considerations to keep in mind. When it comes to private equity, one of the most common situations that investors face is when a friend or family member makes a recommendation regarding a new start-up company or an exclusive private deal, and says that it’s simply “too great to miss”.
It is wise to proceed with caution in these types of situations, as deals that sound too good to be true often are, and can also come with a high degree of risk. Diversification is your friend in private markets as much as it is in public markets. Like any financial decision, it is important to consult your financial advisor to discuss your individual circumstances and whether this type of investment is appropriate for you.