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What to look for in private equity

For the most part, private equity funds have been regulated much less than other assets in the market. That's because high-net worth investors are considered to be better equipped to sustain losses than average investors. But following the financial crisis , the government has looked at private equity with far more scrutiny than ever before.

If you're familiar with the fee structure of a hedge fund, you'll notice it's very similar to that of the private equity fund. It charges both a management and a performance fee. This fee covers the fund's operational and administrative fees such as salaries, deal fees—basically anything needed to run the fund.

As with any fund, the management fee is charged even if it doesn't generate a positive return. The performance fee , on the other hand, is a percentage of the profits generated by the fund that are passed on to the general partner GP. The rationale behind performance fees is that they help bring the interests of both investors and the fund manager in line. If the fund manager is able to do that successfully, he is able to justify his performance fee.

While many different opportunities exist for investors, these funds are most commonly designed as limited partnerships.

Those who want to better understand the structure of a private equity fund should recognize two classifications of fund participation. Under the structure of each fund, GPs are given the right to manage the private equity fund and to pick which investments they will include in its portfolios. GPs are also responsible for attaining capital commitments from investors known as limited partners LPs.

What to look for in private equity

This class of investors typically includes institutions—pension funds, university endowments, insurance companies—and high-net-worth individuals. Limited partners have no influence over investment decisions. At the time that capital is raised, the exact investments included in the fund are unknown. However, LPs can decide to provide no additional investment to the fund if they become dissatisfied with the fund or the portfolio manager.

What separates each classification of partners in this agreement is the risk to each.

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LPs are liable up to the full amount of money they invest in the fund. However, GPs are fully liable to the market, meaning if the fund loses everything and its account turns negative, GPs are responsible for any debts or obligations the fund owes. Private equity funds typically exit each deal within a finite time-period due to the incentive structure and a GP's possible desire to raise a new fund.

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  6. However, that time-frame can be affected by negative market conditions, such as periods when various exit options , such as IPOs, may not attract the desired capital to sell a company. The LPA traditionally outlines management fees for general partners of the fund.

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    Investors are usually willing to pay these fees due to the fund's ability to help manage and mitigate corporate governance and management issues that might negatively affect a public company. The LPA also includes restrictions imposed on GPs regarding the types of investment they may be able to consider.

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    These restrictions can include industry type, company size, diversification requirements, and the location of potential acquisition targets. In addition, GPs are only allowed to allocate a specific amount of money from the fund into each deal it finances. Under these terms, the fund must borrow the rest of its capital from banks that may lend at different multiples of a cash flow, which can test the profitability of potential deals.

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    Schoar attributes this to basic supply-and-demand dynamics. By contrast, in alternative vehicles where investors are involved in the selection of the deals, the returns are much better — provided the investors have a record of top-quartile performance in the past, according to the study. Alternative vehicles are most often offered to large, high-profile investors, keeping with a historical trend of concentrating private equity capital among a small group of elite investors.

    Schoar says this has big implications for everyone else.

    3. Who Invests in Private Equity

    This discrepancy in returns was also revealed when looking at different investor types. Schoar attributed the performance discrepancy to a combination of top investors having more experienced investing teams and getting better deals to begin with.

    Lies, damned lies and private equity performance | The Evidence-Based Investor

    So funds tailor the investment vehicles they offer to different investors according to the investors outside options. One way to find out if there is adverse selection is to keep asking the PE managers about all the funds they offer. Ask to see all deals on the table and operate with extreme discernment, Schoar suggested. MBA Through intellectual rigor and experiential learning, this full-time, two-year MBA program develops leaders who make a difference in the world. Investments Newsroom Contact About. More in Private Equity.

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    How to Read the Performance Review Table. The Fund column lists the names of all active partnership investments. Cash In represents capital contributed for investments and management fees.