Funds' Private Affair

The unending search for higher returns has driven many mutual fund managers to place bets on private equity investments.

The list of funds buying up these relatively high-risk securities include prominent players like the (LMOPX Quote)Legg Mason Opportunity fund, run by famed fund manager Bill Miller, and the (PRNHX Quote)T. Rowe Price New Horizons fund. Those funds are accessing private equity through PIPE investments, or private investments in public equities, while the recently launched Giordano Fund buys private-company debt. (Investors will soon even be able to put their money in a private equity exchange-traded fund.)

While the different paths to private equity are all fraught with difficulties, like pricing and liquidity, the recent prominence and profitability of these securities have for now overshadowed the potential dangers.

Just take a look at the numbers. The U.S. Private Equity Index produced an annualized return of 14.47% from 1990 to 2005, vs. 11.33% for the S&P. The comparison becomes even more attractive between 2001 and 2005. In that period, the Private Equity Index returned 9.99%, while the S&P returned 2.61%.

As private equity deals get more front-page play and involve larger amounts of capital, funds have followed the money. PIPE investments tripled from 2004 to 2005 to more than $3 billion, according to Sagient Research Systems. In addition, mutual fund investments accounted for 21% of the PIPE market in 2005, vs. 10% in 2004.

The Securities and Exchange Commission stipulates that 15% of a mutual fund's total assets can be invested in illiquid, or thinly traded, securities such as private holdings. But this rule is fuzzier than it appears at first blush. The SEC also states that an investment, even a private one, can be considered liquid if the fund determines that there are enough buyers who would pay fair value for it.