Just as the characteristics of private equity can lead to higher returns and increased diversification, they also bring risks to private equity that differ quite a bit from those experienced in public equity.
Some of these risks come from the nature of private equity target companies, which are predominantly early-stage ventures (Venture capital and growth sectors) or distressed businesses in need of restructuring (buyouts). Others result from the differences in structure and regulatory restrictions among private equity funds.
Key risk considerations
- Funding risk: Unlike public equity investments, only a portion of an investor’s total capital commitment in a private equity fund is required at the time of the commitment. The remainder is submitted as capital calls are issued by the GP of the fund. The entire commitment may not be paid into the fund for months or even several years as the GP identifies and acquires assets. The unpredictable timing of capital calls may therefore result in an investor keeping funds liquid for that period of time, which could reduce the returns on that capital.
In addition, the risk of not having funds available for capital calls could subject an investor to default and prevent them from investing further capital in the fund.
To mitigate the funding risk, the cycle of capital calls and distributions can be used to create a self-funding portfolio where profits from one private equity investment are reinvested in the capital calls of another. This is especially possible if the fund has a particularly flat J-Curve (See Understanding cash flows, return profile, and diversification in PE investments to learn more about building a self-funding portfolio).
- Liquidity risk: PE investment strategies are highly dependent on a PE manager’s ability to identify attractive opportunities, provide the necessary capital, and then work with the target companies to deploy that capital over time in ways that will foster long-term growth. To be effective, managers must be able to take a long view with investor capital, taking perhaps months to identify the right opportunities and planning their exit strategy sometimes years in advance.
For such practices to be effective, PE funds will generally incorporate “lock-up” periods during which investors may not withdraw any of their capital. While shares can generally be sold to other investors during this time, the lack of formal secondary markets hinders PE investors from finding potential buyers.
In addition, exits may involve IPOs or acquisitions, which take a great deal more time to implement than sales of public shares on an exchange.
For these reasons, investors in PE have an illiquidity risk that differs considerably from public equity funds. In cases where limited secondary sales opportunities may exist, investors may have to accept discounted returns in order to obtain liquidity for their shares prior to their fund issuing distributions.
To address the illiquidity challenges of private equity, Moonfare holds a semi-annual digital secondary market. This structured auction enables investors looking for early liquidity to sell their Moonfare allocations.
- Capital risk: The returns from private equity investments can be affected by numerous factors, including (but not limited to) the skills of the fund manager, the effectiveness of the fund’s strategy, the environment for IPOs, and interest rates.
Moonfare’s process of selecting funds and GPs for its feeder funds provides investors with an additional layer of due diligence that incorporates Moonfare’s deep knowledge of private equity strategies and extensive experience working directly with the top PE firms and General Partners in prior funds.
Other considerations for PE investments
- Management fees: Fund administration and management fees are typically higher in private equity funds than in public funds. In addition, PE fund managers generally earn a share of the fund’s profits as well in order to align themselves with investor goals. When appraising a PE fund, it is therefore important to consider net returns after fees as the most appropriate measure of returns to investors. At Moonfare, we value transparency about fees and aim to present as many investments as we can in net terms.
- High minimums: In contrast to public funds, which have almost no minimum investment requirements, private equity funds can have very high minimums, often exceeding $1 million. This is why Moonfare has worked to open up private equity access to individual investors by reducing investment minimums to as low as $75,000 or €50,000.
- Primary rather than secondary investments: Investments in private companies are primary investments that feed capital directly into target companies to fuel their growth. In contrast, public equity investments are (with the exception of IPOs and other occasional share offerings) secondary transactions between investors, from which the company receives no direct monetary benefit.
Thus, public equity investors are hoping the shares will appreciate as their targets realise incremental growth from capital raised earlier and retained earnings from operations. Private companies, on the other hand, will be deploying the capital invested in them to build their operations and will often have little to no retained earnings to add to that. PE investors therefore tend to experience a dip in value in the early years of their investment (characterised by the “J-curve” shape of their profit graph over time) followed by higher-than-normal growth as the investment begins to generate results.
- Risk of loss: Overall, private equity investments involve a high degree of risk and may result in partial or total loss of capital. By their nature, alternative investments are complex, speculative investment vehicles and are only suitable for qualified investors who have sufficient knowledge and experience to understand the risks involved.
Moonfare expends great effort to mitigate these risks through active selection and due diligence on the funds and managers it makes available. As a result of Moonfare’s thorough due-diligence process, only 5% of the funds evaluated make it into Moonfare.
British Private Equity & Venture Capital Association’s research found that diversifying across multiple funds reduces the risk of loss. A portfolio of 20 funds has a risk of losing any capital over the entire holding period is only 1.4%. This number is reduced even further to close to zero for a portfolio of 50 funds.
Important notice: This content is for informational purposes only. Moonfare does not provide investment advice. You should not construe any information or other material provided as legal, tax, investment, financial, or other advice. If you are unsure about anything, you should seek financial advice from an authorised advisor. Past performance is not a reliable guide to future returns. Don’t invest unless you’re prepared to lose all the money you invest. This is a high-risk investment and you are unlikely to be protected if something goes wrong. Subject to eligibility. Please see https://www.moonfare.com/disclaimers.