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If your wealthy clients haven’t considered private equity, they should. It’s uncorrelated to the stock market and has potential for outsized returns.

Nuts & bolts

There are two main ways to invest: directly, or through a fund. It’s like the difference between buying individual stocks versus mutual funds or ETFs.

To make a proper stock purchase, your clients would need to understand the intricacies of a company’s financials, business model, operations and potential. And most don’t have the time or the resources to build a diversified portfolio. Hence the need for mutual funds and ETFs.

Same goes for private equity investing. “Unless clients have an aptitude for buying and selling companies, and the teams to do it, it’s unlikely they’re going to make acquisitions directly,” says Ian Palm, a partner in the Toronto office of Gowlings.

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As with public funds, investing in private equity funds means delegating decision making. “You’re signing up for the overall strategy; you won’t have a say every time the manager decides to make an investment,” says Sam Sivarajan, head of investments at Manulife Private Wealth in Toronto.

Most private equity funds are limited partnerships. “There’s a general partner who raises the money, evaluates and makes investments, and sits on the boards of some of the companies. Your client becomes a limited partner, signing all the legal documents that say he or she has done due diligence, etc.”

Potential for higher returns is a big draw, but “all private equity investments are riskier than stocks and bonds because they’re illiquid,” says Sivarajan. Typically, a manager spends three to five years investing in companies. She brings the money in incrementally, through capital calls. That means if your client signs up for a $1-million investment, he doesn’t have to transfer the full amount up front. Instead, as the manager buys firms, or interests in them, she’ll call upon him and others in the fund to provide capital.

Missing a capital call is highly punitive, notes Robert Almeida, senior vice-president and portfolio manager at Portland Investment Counsel in Burlington, Ont. In some cases, the client may be forced to exit the fund, forfeiting everything she’s put down.

Investing in a company is one  thing; waiting for returns is another. Funds typically have 10-year life- spans, notes Almeida. During that period, clients usually receive  distributions.

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He adds that diversification within a fund is important, but in the private equity space that’s measured mainly by number of investments, rather than sector or geography. “If I find great private equity investments and they’re all in one sector, so be it. I’ll just have fewer public investments in that sector.” Almeida emphasizes the portfolio’s publicly traded portion should be diversified across sectors and geographies.

Fees and returns

Fund fees are typically 2% and 20%, notes Palm. The 2% is an annual management fee taken off the committed capital of the fund. So if it’s a $200-million fund, the manager gets $4 million a year. The 20% is a performance fee that kicks in if the fund’s returns beat a specified hurdle rate, which is typically between 6% and 8%.

But fees vary by fund type. For instance, a venture capital fund is likely to have management fees north of 2% (see “Variety of risk,”).

Sivarajan notes firms often do yearly funds, which the industry calls vintages. “They may have a 2004 fund that invests over five to eight years, a 2005 fund that invests over five to eight years, etc. The 2004 fund may do great, while the 2005 fund may not do as well.”

Returns can be anywhere from 10% to 30% over the life of the fund. Sivarajan emphasizes 30% isn’t typical, and that it’s possible to lose money.

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While the offering document specifies a term for the fund, in many cases it will allow managers leeway. “They want to make sure that if they’re in a bad market cycle, they’re not forced to dump holdings just to satisfy fund term limits,” Sivarajan says.

To buy in, clients have to be accredited investors. Traditional private equity funds have a $1 million minimum, notes Almeida. But his firm brings it down to as little as $150,000. How? Clients transfer the entire amount up front, rather than responding to periodic capital calls.

“That’s the cost of making these investments available to retail clients,” he says. “While we’re waiting for the money to be called, we hold it in liquid, low-volatility public investments, such as short-term bonds and notes. It’s earning a lower rate of return, but at least it’s working, and we eliminate any risk of clients getting stumped by calls they can’t meet.” Those returns become part of the client’s overall net asset value and can be used to cover the private equity fund’s fees and expenses.

Those investing larger amounts can keep the money with their advisors, meeting calls themselves. Advisors with clients going this route, Almeida says, should also keep the assets liquid.

Payback time

There are three main ways fund managers make distributions to investors, says Palm.

“The most common is through some sort of M&A transaction.” This can mean selling the company outright and distributing the sale proceeds to investors.

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