Primer on private equity

If you’re a wealthy investor and haven’t considered private equity, you 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, you would need to understand the intricacies of a company’s financials, business model, operations and potential. And most investors 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 [you] have an aptitude for buying and selling companies, and the teams to do it, it’s unlikely [you’re] going to make acquisitions directly,” says Ian Palm, a partner in the Toronto office of Gowlings.

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. [You become] 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 you sign up for a $1-million investment, you don’t have to transfer the full amount up front. Instead, as the manager buys firms, or partial interests in them, she’ll call upon those in the fund to provide capital.

Missing a capital call is highly punitive, notes Robert Almeida, managing partner at Portland Investment Counsel in Burlington, Ont. In some cases, you may be forced to exit the fund, forfeiting everything you’ve put down.

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

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 that your 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%.

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.

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.

Learn about four types of private equity investing here.