Private equity can evoke dreams of finding the next Intel or Microsoft or images of fat cat bankers dressed in Armani suits, smoking expensive cigars and contemplating their next big deal.
But private equity can make a useful contribution to any investment portfolio. Studies have shown that private equity returns do not correlate closely with returns from other asset classes, such as bonds and public equities, so having an allocation in private equity can help smooth out the returns of a balanced portfolio.
Private equity relates to investment strategies involving the equity in companies not listed on a stock exchange. Finance is provided by firms which generally raise funds from investors such as pension funds, financial institutions, charities and endowment schemes.
The companies funded by these private equity firms cover the whole business spectrum from high-tech companies to established old-line manufacturing companies. However, all private equity deals have key features in common – sophisticated financial investors, highly motivated managers and the opportunity for both groups to make money. To achieve this, investors and managers must work together to create value by improving profitability, growing sales or purchasing related businesses and combining the pieces to make a bigger company.
Private equity firms point to various factors which make investments in this asset class attractive. Most obviously, the investment returns can be high but not without risk. In addition, information can be more easily obtained and due diligence more effectively undertaken than with listed companies.
Pricing volatility is also lower, timescales can be set by management and not sentiment and – most important – the company's destiny is controlled by the collaboration of management and private equity investors, not the vagaries of the stockmarket.
The last 10 years have witnessed an explosive growth in the popularity of private equity, due to a number of factors. Investors have shifted from fixed income to equity investing, there has been a proven outperformance in private equity compared with virtu-ally all other markets and the overriding inclination toward conservatism among asset allocators has changed.
Only last year, the Myners report recommended that pension funds increase their exposure to the private equity asset class through funds of funds.
Despite this growth, investing directly in private equity funds is very difficult for many individuals and small institutional investors. The premier private equity funds are inaccessible to all but the highest-net-worth investors.
As with all good parties, these funds are often by invitation only. The only way to gain access is either by charming the private equity group for an invitation or using an experienced and respected fund of funds manager who has the background, contacts and experience to be on the guest list.
You have to decide on your own investment strategy and know your own skill set. Should you have a particular focus or be diversified, domestic or international – or both? If you do not know, find someone who does. You have to decide whether you are qualified to invest in private equity or whether to subcontract manager selection to someone else.
Investors should be wary of some of the more popular private equity myths. All private equity managers will claim a proprietary deal flow and a unique investment strategy. All will say their track record ranks among the top 25 per cent of managers and almost all claim to add value in the post-transaction, pre-realisation phase.
The selection of the fund manager is the overriding decision and requires thorough due diligence. Do they have the core competencies, the research capability, a cohesive team, the experience they claim and the contacts they list? How do they compare with other private equity funds? How do their terms compare?
Due to the complexity of this decision process, private equity funds of funds have grown rapidly in popularity in recent years. The fund of funds manager effectively integrates the investable assets of many investors into a single vehicle and invests this pool of money to assemble a diversified portfolio of private equity funds.
Private equity is generally considered to be a high-risk, high-return asset class that can enhance the returns of a well-diversified investment portfolio. The main concerns that most people cite are lack of liquidity, loss of control, the business cycle and manager risk.
Lack of liquidity is less of an issue than it might appear. If you invest in private equity through an investment trust listed on the London Stock Exchange, you can buy and sell the investment in the same way as any other share. If you are able to invest in funds directly, there is a fairly strong secondary market for private equity funds with several leading players focusing exclusively on this sector.
Concerning control, professional private equity managers are able to negotiate rights often unavailable from listed investments, ensuring control of specific corporate events, activities and spending. These rights are commonly included in the contracts concluded at the point of acquisition.
The risks in the business cycles of private equity investments are the same as in any other asset class. It is manager risk which is often the biggest gamble. This risk is considerable and brings us back to my comments on investment strategy and the use of funds of funds. Use experts for manager selection. It is all about due diligence. The incremental cost of using an expert for manager selection is dwarfed by the profits you earn from being right compared to the enormous cost of getting it wrong.
So is private equity more risky than the listed markets? I think the shareholders of companies such as Marconi and Enron will tell you about the high risks in listed markets. It is not the asset class that provides the risk, it is the success, or otherwise, of each investor's individual strategy that will determine performance.
Private equity has a place in many portfolios but it is generally best practised by experts. Make sure, when considering an investment, be it in a trust or fund of funds, that your preferred manager has the experience to make informed, balanced and reasoned decisions based on process, due diligence and professional judgement.
This will help minimise losses and, hopefully, generate the profits that investors have come to expect from this most interesting of asset classes. In short, find the right manager and you have found the right product.