Private Equity Investments Potentially Offer Attractive Returns But With Notable Risks
A recent study by three researchers at the Center for International Securities and Derivatives Markets (CISDM) at the University of Massachusetts Amherst examines the advantages and disadvantages of private equity investing. In announcing their findings, Mr. Schneeweis, Mr. Gupta and Mr. Szado observe that in North America, investment allocations in private equity among institutional portfolios are expected to grow to more than 7.5 percent of total traditional and alternative asset allocations. That percentage represents a substantial dollar allocation. Let’s examine the major findings of the research, as well as its major warnings to prospective investors. First, what is private equity investing? The researchers define it as securities that are not publicly traded, generally are illiquid, with time horizons spanning as long as eight to ten years. Private equity investments typically are classified into four distinct strategies. These strategies are: venture capital; leveraged buyouts (LBO); mezzanine investing; and distressed debt investing. Companies (ranging from start-ups to mature companies) typically seek financing from private equity funds to fund an acquisition, to grow, to develop products or for other business purposes designed to generate more company profits. Second, how does one invest in private equity? The researchers list several ways to do so. Most convenient, investors can purchase shares of the private equity firms themselves which trade on a public exchange (such as the Blackstone Group, L.P., which trades on the New York Stock Exchange). Likewise, investors can invest in closed-end funds (referred to as business development companies) which invest in private equity. Additionally, there are indexes that track the performance of certain kinds of private equity, such as the LBO index and LPX set of indexes that track buyout or mezzanine capital investments. Finally, there is direct investment in private equity. Here, investors become limited partners pursuant to the terms of a limited partnership agreement. The researchers note that the typical investment has a fixed term that is ten years or more and requires limited partners to commit to placing additional capital at various stages. Limited partners who are unable or unwilling to commit additional capital face severe penalties that can result in a loss of the entire initial investment. Moreover, limited partners may not be able to terminate their agreements except under extreme circumstances. Third, the researchers find that long term performance of private equity investments is superior to the performance of public equity investments. The reason is twofold. First, private equity “is able to access the vast and growing marketplace of privately held companies that are not available in traditional investment products.” Second, private equity “can create value by proactively influencing invested companies’ management and operations, thereby generating excess returns over conventional stock and bond investments.” In addition, the researchers state that, “The results suggest that traditional private equity indexes may provide diversification and return benefits when added to an existing stock and bond portfolio or to an existing mixed traditional (stock and bond) and alternative (hedge funds, commodity trading advisors, real estate, and commodity) portfolio.” The researchers do concede that, while private equity indexes
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overall outperformed stocks and bonds during the period 1994-2006, private equity indexes have underperformed during the period 2001-2006. Fourth, prospective investors must consider the risks of private equity investing. The researchers outline several disadvantages that must be considered. They are, as mentioned above, the long term investment time frame (commitment), the lack of liquidity, and the required subsequent investment capital calls. Additionally, investors must be concerned that a private equity fund may “blow up”. The researchers cite, as a recent example, an investment in Washington Mutual by a major private equity group, Texas Pacific Group (TPG). TPG resulted in failure when Washington Mutual filed for bankruptcy. Overall, private equity investments potentially offer attractive returns, but with notable risks. Prospective investors and their advisers must understand them, before they invest!
About the Author: James J. Eccleston leads the Securities group at the Chicago law firm of Shaheen, Novoselsky, Staat, Filipowski & Eccleston, P.C., where he represents investors in recovering investment losses and financial services professionals in disciplinary, employment, and compliance matters. He has held numerous securities licenses and Chicago Bar Association leadership positions and serves as an arbitrator and mediator. He is a recipient of Martindale-Hubbell’s highest rating (AV) for legal ability and ethics and is named to the Illinois Super Lawyer and Leading Lawyer lists. Contact info: JEccleston@snsfe-law.com, 312.621.4400, www.snsfe-law.com, www.financialcounsel.com
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