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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Another is through a dividend recapitalization transaction. Most private equity funds use leverage to buy companies. For instance, if a fund is buying a $50-million company, it may make an equity contribution of $20 million and borrow the rest. The $30-million loan is paid back with cash flow the company generates. Any additional cash flow can pay dividends. But the manager can also go back to a lender (not necessarily the same one) for additional financing and make a distribution of a portion of those loan proceeds to fund investors. Palm notes the lender will likely allow only a percentage of the additional loan to be used for this purpose. The rest would go towards the company’s working capital, for instance. That additional debt is paid off over time with future cash flow.

The third way is through an IPO. “An example of this is Dollarama. It was private-equity backed, then did an IPO and the private equity manager distributed shares to fund investors.”

Due diligence

Advisors should evaluate a fund manager against its peers, Palm says. “A top-quartile fund has historically outperformed comparable public equity indexes over time. If a fund isn’t in the top quartile, it’s unlikely to. Selecting the right managers is key to successful private equity investing.”

The management team should demonstrate two skill sets, says Almeida. One is financial analysis skills; the other is business operations skills. “You want to know they actually understand the underlying businesses. They have to know how to interact with entrepreneurs, and that means having some of that entrepreneurial spirit themselves.” Almeida determines this by speaking with company owners the managers have worked with in the past.

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You also want to consider how long the management team’s been together. “If it hasn’t been long, or if turnover’s high, it may mean there will be a breakup while you’re an investor,” suggests Almeida.

And while the fund’s team may do a good job building up and improving the companies they buy, “if they’ve had limited success selling companies, investors don’t get their capital back.”

It’s also critical, says Almeida, that the fund company have some skin in the game. The industry benchmark is about 2.5%.

Sivarajan adds: “You want to make sure it’s going to be painful if the investment flops. If firm principals are worth $10 million and they only have $100,000 invested, it isn’t going to hurt that much. It has to be meaningful enough for you to [conclude] they’re not just playing with your money.”

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Almeida notes the offering document will say how much the company’s put in. If it’s nothing, don’t invest. But the offering document may not tell you whether individual managers have positions. Ask. “If they say individual managers are not putting anything in the fund, it’s not necessarily a complete walkaway but it’s a red flag.”

Sivarajan suggests clients making their first forays into private equity should consider a smaller initial investment, even if the firm is reputable. If the experience is good, they can invest larger sums.

He also says it’s important to get the client’s lawyer and accountant involved. The limited partnership documents usually have a clause that says the investor has had the opportunity to consult her team of advisors.

Sivarajan suggests clients approach these investments the way they would buy real estate. “If you were going to buy a house, would you do it without getting a home inspection and a lawyer to do the documentation?”

Variety of risk

Private equity funds typically fall into one of four categories based on the companies they invest in, notes Robert Almeida, senior vice-president and portfolio manager at Portland Investment Counsel in Burlington, Ont. They are:

  1. Venture: A new business with limited experience; sold on growth potential;
  2. Growth: An existing, proven business; investors help it pursue a growth strategy, such as building a new plant, or M&A activity;
  3. Distressed: The underlying business is strong, but it has a temporary cash problem; investors fill the gap
  4. Buyout: When a company’s purchased from its existing owner; this uses leverage strategies to optimize the company’s capital structure.

Also on offer are specialty funds by sector, such as infrastructure and real estate.

Sam Sivarajan, head of investments at Manulife Private Wealth, says risk level varies across categories. “Venture capital is on the high end of the risk spectrum because you’re betting on technology or a business model that may not be proven.”

Leveraged buyouts have less risk, he suggests. In these cases, the manager is looking for mid-market, old-economy companies (manufacturing, for instance) that are family-owned and may not have an optimal operating or capital structure. “Private equity managers come in and get it right, and use their networks and relationships to build more revenue opportunities.

“Risk and return are highly correlated. The potential for a tenbagger [an investment that appreciates by 10 times] is higher with venture capital than it is for leveraged buyouts.”

Dean DiSpalatro is senior editor of Advisor Group.