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

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Legg Mason Opportunity fund, run by famed fund manager Bill Miller, and the

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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.

However, Morningstar analyst Todd Trubey says private equity is still relatively rare in the mutual fund space.

"Certainly, I can see how it would be very tempting," Trubey says. "You read all about private equity these days. People get the sense that there's something going on there and they want to get involved. But this remains something very rare."

In general, mutual funds are tapping the growing marketplace of privately held companies through PIPE investments, buying private company debt and investing in the private company itself.

Pricing Problems

Eric Newman, a portfolio manager at TFS Capital, uses alternative investment techniques for his fund, but says he avoids private equity because of pricing issues.

"We're always happy to see mutual funds offering alternative strategies to the retail investor, but we're not sure if private equity is the best fit for an open-ended fund that you need to price on a daily basis," says Newman.

"You have this security that doesn't trade on exchange, so the market is not setting its price. It's hard to really know what its fair value is."

Morningstar's Trubey agrees, adding that being confident about pricing is crucial. "One of the most prominent examples of this sort of thing was with Garrett Van Wagoner. People thought there were significant issues with stewardship at his funds. The trouble came because of problems with fairly pricing securities."

In 2004, the SEC charged

Van Wagoner Capital Management

with deliberately undervaluing private investments in its mutual funds to make it seem as if illiquid securities were within the 15% limit. The settlement with regulators did not confirm or deny any wrongdoing.

Illiquidity Issues

"When things are illiquid, then the supply is limited, and that increases the potential for returns," says Trubey. "It's the same sort of thing you see with micro-caps. You can potentially hit massive home runs with this sort of thing."

However, the liquidity issue can also harm a fund that invests directly in private companies, like

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Firsthand Technology Innovators. If a company that Firsthand invests in hits a major bump, the holdings are hard to trade.

"Oftentimes, the only option if you buy a stake in a private company is to sell it back to the company," says Trubey. The problem is similar for funds that buy private-company debt. If those bonds falter, the only market option is to sell them back to the company.

And watch out for the fees at funds that invest in private equity. The holdings could push up expenses, because it takes a legal team to thoroughly review the deals, and it takes more work for the manager to fairly value securities that are not priced by the market.

Firsthand Technology Innovators, which has an average five-year return of negative 8.15%, has a 1.95% expense ratio. Legg Mason Opportunity fund has a 2.08% expense ratio, but a five-year return of 9.97%.

"Bill Miller at Legg Mason is investing in private equity through PIPE deals, and he's one of the brightest guys out there and a very long-term investor," says Trubey. "If the Opportunity Fund's holdings are illiquid, Miller probably wasn't going to sell the stake quickly anyway, and he can ride out a bad period in whatever the security is." The Opportunity Fund is down 4.81% year to date.

"When you're dealing with these kinds of stakes, it demands that you trust the manager more," says Trubey.