When a process is working, standard knowledge suggests leaving it alone. If it is not broken, why fix it?
At our firm, though, we would rather devote further energy to making a great process great. Instead of resting on our laurels, we’ve spent the previous couple of years specializing in our private equity research, not because we’re dissatisfied, but because we believe even our strengths can change into stronger.
As an investor, then, what should you look for when considering a private equity investment? Lots of the same things we do when considering it on a client’s behalf.
Private Equity one hundred and one: Due Diligence Fundamentals
Private equity is, at its most simple, investments that aren’t listed on a public exchange. However, I use the term here a bit more specifically. After I talk about private equity, I don’t imply lending money to an entrepreneurial pal or providing different forms of venture capital. The investments I talk about are used to conduct leveraged buyouts, where large amounts of debt are issued to finance takeovers of companies. Importantly, I’m discussing private equity funds, not direct investments in privately held companies.
Before researching any private equity funding, it is essential to understand the general risks involved with this asset class. Investments in private equity could be illiquid, with investors usually not allowed to make withdrawals from funds through the funds’ life spans of 10 years or more. These investments even have higher bills and a higher risk of incurring giant losses, or even a full lack of principal, than do typical mutual funds. In addition, these investments are sometimes not available to investors unless their net incomes or net worths exceed certain thresholds. Because of those risks, private equity investments are usually not appropriate for a lot of particular person investors.
For our shoppers who possess the liquidity and risk tolerance to consider private equity investments, the fundamentals of due diligence have not changed, and thus the inspiration of our process stays the same. Earlier than we advocate any private equity manager, we dig deeply into the manager’s investment strategy to make sure we understand and are comfortable with it. We need to be sure we’re totally aware of the particular risks concerned, and that we can establish any red flags that require a closer look.
If we see a deal-breaker at any stage of the process, we pull the plug immediately. There are many quality managers, so we don’t feel compelled to take a position with any particular one. Any questions we have now should be answered. If a manager offers unacceptable or unclear replies, we move on. As an investor, your first step ought to always be to understand a manager’s strategy and be certain that nothing about it worries you. You’ve gotten loads of different choices.
Our firm prefers managers who generate returns by making significant operational improvements to portfolio firms, slightly than those who depend on leverage. We additionally research and consider a manager’s track record. While the choice about whether or not to speculate shouldn’t be based mostly on previous funding returns, neither should they be ignored. On the contrary, this is among the many biggest and most essential pieces of data about a manager you could easily access.
We also consider each fund’s “classic” when evaluating its returns. A fund that started in 2007 or 2008 is likely to have decrease returns than a fund that began earlier or later. While the truth that a manager launched earlier funds just before or during a down interval for the financial system just isn’t an instantaneous deal-breaker, take time to understand what the manager realized from that period and the way he or she can apply that knowledge within the future.
We look into how managers’ earlier fund portfolios have been structured and learn the way they expect the present fund to be structured, specifically how diversified the portfolio will be. How many portfolio companies does the manager count on to own, for instance, and what’s the maximum amount of the portfolio that may be invested in any one company? A more concentrated portfolio will carry the potential for higher returns, but also more risk. Buyers’ risk tolerances fluctuate, but all ought to understand the quantity of risk an funding involves before taking it on. If, for instance, a manager has performed a poor job of developing portfolios previously by making large bets on corporations that did not pan out, be skeptical concerning the likelihood of future success.
As with all investments, one of the vital vital factors in evaluating private equity is fees, which can seriously impact your long-time period returns. Most private equity managers still charge the standard 2 % administration payment and 20 percent carried interest (a share of the profits, typically above a specified hurdle rate, that goes to the manager earlier than the remaining profits are divided with traders), but some might charge more or less. Any manager who charges more had higher give a clear justification for the higher fee. We have never invested with a private equity manager who expenses more than 20 p.c carried interest. If managers charge less than 20 p.c, that can obviously make their funds more attractive than typical funds, although, as with the opposite considerations in this article, fees should not be the sole foundation of investment decisions.
Take your time. Our process is thorough and deliberate. Make sure that you understand and are comfortable with the fund’s internal controls. While most fund managers will not get a sniff of curiosity from buyers without robust inner controls, some funds can slip by means of the cracks. Watch out for funds that do not provide annual audited monetary statements or that can’t clearly reply questions about where they store their cash balances. Feel free to visit the manager’s office and ask for a tour.
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