NEW YORK (MainStreet) –- So you think a private equity fund can do more for your money than a mutual fund? Give it some more thought.
Paul Jacobs, chief investment officer of Palisades Hudson Financial Group in Atlanta, notes that adding private equity funds to your portfolio can lead to higher returns and lower risk over the long term. However, selecting a private fund requires a lot more homework than picking from your typical mutual fund.
For one thing, private equity funds aren't for everybody. Private equity funds are typically limited partnerships with a lifespan of about ten years, and some have a minimum investment as low as $100,000 and are available. That makes them available to affluent investors, but keep in mind that's the low-end buy-in. Other funds require specifically more wealth.
“For the right investor, the rewards can be substantial,” Jacobs says.
Private fund managers can take a more active role with the companies they acquire and potentially wring out higher returns than mutual fund managers. Their “leverage” (borrowing) can produce higher returns by buying up companies and improving operations and profits.
“Look for managers who generate returns by making significant operational improvements to portfolio companies, rather than those who rely on excessive leverage, which adds risk,” Jacobs says. "However, with judicious use of leverage, a skilled manager can deliver excellent results.”
Also, realize that a private equity fund is going to tie up your money for ten years or more, so you're going to want to get a good handle on a manager's investment strategy and the risks involved before diving in. How were the manager’s previous fund portfolios were structured? How does he or she expect the current fund to be structured and diversified? How many portfolio companies does the manager expect to own, and what is the maximum amount of the portfolio that can be invested in any one company? A more concentrated portfolio will carry the potential for higher returns, but also more risk.
Don't be afraid to ask the tougher questions, either. Does a fund provide annual audited financial statement? Can the manager tell you where the fund stores its cash balances? Can you visit the manager’s office and get a tour? If the answer to any of these questions is no, or if your fund manager wants more than 20% of the end profits (carried interest), then don't be so quick to part with your investment or the management fee. Also, it helps if the manager believes in his or her own cooking.
“Active management—in the right hands—can build wealth faster and more reliably than an index strategy,” says Frank Congemi, an investment advisor in Deerfield Beach, Fla. “And while past results don’t guarantee future results, this methodology is the most convincing I’ve seen... The beauty of high manager ownership is that these people are literally putting their money where their mouth is.”
If you like what you see, Jacobs says that managers' fees for private equity funds are incredibly negotiable. However, he advises limiting your exposure to those funds to about 10% to 20% of your entire portfolio, given the risk involved.
As we mentioned, however, private equity funds are not for everyone. As Jacobs notes, these funds have higher risk of incurring large losses, or even a complete loss of principal, than do mutual funds. You're putting a lot more at stake when you're doing your homework, so if something doesn't seem quite right about the fund or you don't think you have enough to risk, there are always other options.
Benjamin Sullivan, a certified financial planner with Palisades Hudson's office in Scarsdale, N.Y., realizes that ETFs and mutual funds can seem boring in contrast to private equity funds or investing in private companies, but investors can get excited about sensible investing if they think about it the right way.
“Investing in an index fund won’t give you a rush of adrenaline like seeing your stock going up 10% in a day, but, ultimately, it’s more exciting to see your portfolio double and triple in value over the years,” he says, noting that actively managed mutual funds can provide similar reward if an investment manager has an eye for undervalued companies. “Index equity funds are bedrock investments, but actively managed funds can play a key role too once you have a reasonable amount of money to invest,”
If that mix sounds a bit more comfortable, Sullivan recommends putting about 60% of equity investments in index funds in established markets like the United States, Japan and Europe. The other 40% should go into actively managed funds that invest in small-cap stocks, emerging markets and specialty areas such as REITS. Just avoid funds with excessive fees.
“With private companies, if you’re lucky, you may hit a home run, but far more often, you’re going to strike out,” Sullivan says. “Hitting singles and doubles consistently with funds is the time-tested way to build long-term wealth.”
This article is commentary by an independent contributor. At the time of publication, the author held TK positions in the stocks mentioned.