Doing Your Due Diligence on a Private Equity Investment Offer

Retirement Planning | Taxes & Tax Planning | Retirement Tax Planning

 Jacob Malina By: Jacob Malina

In our Plancorp Family Office practice, we often work with clients who are frequently presented with opportunities to invest in non-traditional offerings such as private equity, private real estate, hedge funds, etc.

First things first. We ultimately believe a family’s “core” wealth is best managed with a portfolio of liquid, low-cost, globally diversified mutual funds, or exchange traded funds (ETFs). But we also understand, some clients may exhibit a strong appetite for risk within an “explore” portion of their wealth. For them, high-risk/high potential reward opportunities may have an appeal as well.

Even if private equity may be right for you, how do you decide: Out of the huge haystack of private equity opportunities available, which are the proverbial needles worth selecting? You might think you can spot a winner because it has “private” in its title, it’s had a nice historical return, or an all-star manager is in charge.

In reality, none of these factors tells you much about what to expect from the investment moving forward. The following are considerations you should be making instead when evaluating illiquid investment opportunities.

Ask Why

In his book “Your Money and Your Brain,” Jason Zweig discusses the value of repeating one simple question: “Why?”

“Asking ‘Why?’ four or five times is a good way to test the limits of your own (or someone else’s) knowledge,” says Zweig.

So, if someone tells you something is a great investment, ask why. If their response is that their advisor, friend, or neighbor told them so … ask why they feel it is a good investment. If a fund manager tells you this investment will take advantage of the fastest-growing market segment, ask why it is going to be the fastest-growing market segment. Continuing to ask why can vet who does, and does not know what they are talking about. If the fund manager can’t get past three or four “why’s,”—with answers you understand—you may want to think twice (or four or five times), before giving them your money.

Mechanics, Costs and Returns

What are you actually investing in, and what is it really going to cost you? A private equity fund’s Private Placement Memorandum (or Offering Memorandum) is often the best place to go for this sort of information. Among other details, this document provides the terms of the deal, potential risks, and expected costs. Be sure to review the costs carefully to get a firm understanding of how the fund manager is paid. What percentage of your investment is going toward salaries, organizational costs, or administrative fees instead of being invested? How long is your cash sitting on the sidelines before it’s deployed?

Another consideration is how you, the investor, are paid. Is the partnership taking a substantial cut of the profit prior to distributing to investors? And if so, how big is the cut? Fees can often create the largest hurdle for investors trying to achieve outperformance. You can reduce ugly surprises come distribution time by making sure you understand how you are getting paid, and who is getting paid first.

Evaluating the General Partner/Fund Manager

When you invest in an index fund, how the fund is managed is more important than who is managing it, since an index fund simply captures a market’s expected returns by maintaining the fund’s prescribed asset allocations. In contrast, when looking at private and illiquid investments, you’re not just trying to capture available market returns; you’re trying to beat them through fund manager outperformance.

So, as a private equity investor, try to understand what steps the fund manager is taking in pursuit of outperformance. As I mentioned above, this is where you want to drill into the “why” when the manager says they have a “unique” opportunity to deliver premium returns.

This means more than just taking a manager’s past performance at face value. Why did they outperform, and why might you expect that outperformance to persist (or not)? Below are a few questions to consider when evaluating a private equity fund’s general partner:

  • Does the entire deal depend heavily on one, “all-star” player? What is the succession plan should something happen them?
  • What is management’s experience and credentials? While a solid background doesn’t guarantee success, a lack thereof can be telling.
  • Are the general partner’s incentives and interests aligned well with the limited partners’ interests (i.e., yours)? Does the GP have their own money invested in the fund, with “skin in the game”? If not, this may be a sign you could get fleeced.

Structural Considerations

Lastly, it helps to fully understand how the fund is structured, and what you can expect for the money you commit to it. For example, take a close look at these details:

  • Committed capital draws. Is there a schedule for when managers will ask for additional capital investments? If not, how much time do you have to send them more capital upon request? What are the penalties if you don’t provide it?
  • Exit strategies. Is there a clearly defined exit strategy for getting your money back?
  • Lockup Periods. What are their policies on declaring lockup periods (when you are prohibited from withdrawing capital or redeeming shares from the fund)?
  • Redemption policies. What advance notice must you give to redeem shares in general? (It’s usually 30–90 days.) How much will it cost to redeem shares?
  • Fund-raising targets. How close are the fund managers to meeting their fund-raising targets? Who else are they targeting?

Next Steps …

Would you like to further strengthen your decision-making discipline? Consider grabbing a copy of the newly published “Noise: A Flaw in Human Judgment,” co-authored by Nobel Laureate, Daniel Kahneman. Or read Zweig’s recent review of the book, for some of the key decision-making pointers Kahneman and his co-authors offer. These include:

  • Thinking twice about first impressions
  • Ranking the components in your decisions (so one detail doesn’t overshadow bigger concerns),
  • Seeking multiple opinions
  • Sleeping on it before deciding

Speaking of multiple opinions, while we do not seek out private and illiquid investment deals for our clients, our Family Office practice is happy to review the ones you have in mind, and offer you our informed and objective opinion on them. Should you proceed, we also can help you plan around the holding, and help you assess how it fits into your overall financial picture.

Have you been presented with the opportunity to invest in an alternative investment such as a private equity fund? Could you use some help deciding if it’s the right fit for your financial situation? Click the image below to schedule a 15-minute consultation with our Family Office team, and learn how we help clients make clear, confident decisions for themselves and their wealth.

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Disclosure:

This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors

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Originally from the Chicagoland area, Jacob joined Plancorp in 2017. Jacob’s passion for helping clients find the best financial solutions and the challenge of working through complicated financial situations makes him a natural fit for Plancorp. He says he was especially drawn to our firm because of our team-based culture and focus on employee development. More »