Understanding Investments in Private Equity
Last year, the California Public Employees’ Retirement System (CalPERS)—the nation’s largest pension fund—publicly disclosed that more than $3 billion has been paid out over the past 17 years in performance fees to private equity managers. During this same time period, more than $24 billion has been made in profits.
Public pension funds, foundations, university endowments, sovereign wealth funds, and other institutional investors have made their private equity investing portfolios transparent as well. This gives investment advisers incentive to take the time to research the asset class for unique characteristics and private equity fund managers’ fees to customers.
The focus of private equity firms is providing their investors with outsized returns while maintaining structured fees. With private equities outperforming public equities and fixed income over the past two decades, the profit-sharing arrangement has proven to be an effective method in providing incentives to private equity fund managers and investors. Investors should know, though, that future results are not guaranteed because of the success of past performance.
Before an investor can be deemed eligible for to invest in a private equity fund, they must qualify based on the fund’s requirements. In most cases, a person will not qualify with less than $5 million in investible assets, and a company will not qualify with less than $25 million in investible assets. This can depend on the minimum commitment level set forth by the private equity fund.
Fees for private equity funds are very high – investors are normally charged an annual management fee by the fund manager – usually 1.5 to 2 percent. Also, there is typically a 20 percent share of profits that is paid to the fund manager at the fund’s end date.
The distributions follow a waterfall structure. This means that in the beginning, distributions are allocated to investors so they can get their money back and preferred return. After reaching the hurdle rate, distributions are typically allocated mostly to the general partner. Distributions will be allocated 80% to investors and 20% to the general partner until the general partner has caught up to his or her share of total profits. After the catch-up, the remaining profits are distributed 80% to the limited partner and 20% to the general partner.
With the long time horizon of these funds, high fees, and their illiquidity, it is important to do some diligence to understand what you’re actually investing in and whether it makes sense for you.