Considerations When Evaluating Equity finance

When a process is working, conventional wisdom suggests leaving it alone. If it isn't broken, why repair it?

At our firm, though, we'd rather devote extra energy to cooking a good process great. Instead of resting on our laurels, following the last few years focusing on our equity finance research, not because we are dissatisfied, but because we presume even our strengths may become stronger.

As an investor, then, what should you look for when considering an individual equity investment? A lot of the same things perform when considering it over a client's behalf.

Private Equity 101: Due Diligence Basics

Equity finance is, at its most elementary, investments that are not on a public exchange. However, I personally use the term here more specifically. When I talk about private equity, I do not mean lending money to an entrepreneurial friend or providing other kinds of venture capital. The investments I discuss are used to conduct leveraged buyouts, where large amounts of debt are issued to finance takeovers of companies. Importantly, I am discussing private equity funds, not direct investments in privately owned companies.

Before researching any private equity finance investment, it is crucial to understand the general risks included in this asset class. Investments in private equity can be illiquid, with investors generally unacceptable to make withdrawals from funds throughout the funds' life spans of 10 years or more. These investments also have higher expenses as well as a higher risk of incurring large losses, or possibly a complete loss of principal, compared to typical mutual funds. Additionally, these investments will often be not available to investors unless their net incomes or net worths exceed certain thresholds. For these particular risks, private equity investments are certainly not appropriate for many individual investors.

For the clients who develop the liquidity and risk tolerance to consider private equity investments, the basic principles of due diligence never have changed, and thus the building blocks of our process remains to be the same. Before we propose any private equity manager, we dig deeply into the manager's investment technique to make sure we understand and are comfortable with it. We should instead be sure we are fully aware of the particular risks involved, therefore we can identify any warning flag that require a closer look.

Whenever we see a deal-breaker at any stage in the process, we end the deal immediately. There are many quality managers, and we all do not feel compelled to invest with any particular one. Any queries we have must be answered. If a manager gives unacceptable or unclear replies, we go forward. As an investor, decide on should always be to understand a manager's strategy and ensure that nothing about this worries you. You have plenty of other choices.

Our firm prefers managers who generate returns by making significant operational improvements to portfolio companies, as an alternative to those who rely on leverage. We also research and evaluate a manager's reputation. While the decision about whether to invest should not be depending on past investment returns, neither when they are ignored. On the contrary, this is among the biggest and most important pieces of data of a manager that you can easily access.

We consider each fund's "vintage" when searching for its returns. A fund that began in 2007 or 2008 may well have lower returns when compared to a fund that began earlier or later. Even though the fact that a manager launched previous funds ahead of or during a down period to the economy is not an instant deal-breaker, remember to understand what the manager learned from that time and how he or she can apply that knowledge in the future.

We look into how managers' previous fund portfolios were structured and find out how they expect the actual fund to be structured, specifically how diversified the portfolio will probably be. How many portfolio companies does the manager expect to own, as an example, and what is the maximum amount of the portfolio that can be invested in any one company? An even more concentrated portfolio will carry the opportunity of higher returns, but also more risk. Investors' risk tolerances vary, but all should understand the amount of risk an investment involves before taking it on. If, for instance, a manager has done a poor job of constructing portfolios in the past by making large bets on companies which didn't pan out, keep clear about the likelihood of future success.

As with all investments, one of the most key elements in evaluating private equity is fees, which could seriously impact your long-term returns. Most equity finance managers still charge the conventional 2 percent management fee and Twenty percent carried interest (a share in the profits, often above a specified hurdle rate, that goes to the manager prior to remaining profits are divided with investors), however, many may charge approximately. Any manager who charges more ought to give a clear justification for the higher fee. We've never invested using a private equity manager who charges greater than 20 percent carried interest. If managers charge below 20 percent, that can obviously make their funds more attractive than typical funds, though, as with the other considerations in this article, fees should not be the sole basis of investment decisions.

Take some time. Our process is thorough and deliberate. Make sure that you understand and are more comfortable with the fund's internal controls. While most fund managers will not get a sniff appealing from investors without strong internal controls, some funds can slip through the cracks. Watch out for funds that don't provide annual audited fiscal reports or that cannot clearly fix where they store their own balances. Feel free to look at the manager's office and request a tour.

The more or less open secret in the private equity industry is that things are negotiable. See if you can negotiate lower fees or, if you would like it, a reduced minimum commitment. At private equity's peak in 2006 and 2007, managers had each of the leverage, so negotiating using them was difficult. The tables have turned, also it can be much easier to set up an investment on your own terms, particularly for investment managers and institutional investors, but with a lesser extent for individuals as well.

Next Steps: Beyond And Beyond

Times change. Even though the fundamentals remain largely the identical, private equity is an industry like every other, which means that new ways of thinking and different approaches arise. We be dilligent about staying current with trends and issues in the industry.

The tools and data open to advisers have improved, even though more information can ultimately make our jobs easier, will still be up to us - as it's to investors performing their unique due diligence - to help make the best use of the data. For example, when our Investment Committee evaluates a personal equity manager, supermarket look for managers who follow similar strategies so we can compare them. Even though a manager passes the whole tests, we find that it must be still worth looking at other managers to view how they compare.

One particular item of data that has been easier to find is how a great deal of manager's investment return was as a result of the manager's expertise and operational improvements to portfolio companies and exactly how much to the macroeconomic environment or leverage. Some managers might not be able or prepared to provide this information, nevertheless for those who are, it can be beneficial in providing an obvious measure of how much value a manager added.

We also have created formal procedures to make sure that our client private equity portfolios are diversified by strategy and vintage. We do not have a maximum that people recommend for any one strategy or vintage, because each client has different goals and risk tolerance. But with the help of this step and keeping track of diversification in a disciplined way, we seek to generate higher returns minimizing risk over the long term.

We now have also devoted more time to considering each client's target equity finance allocation. In the past, organic beef have recommended an optimum 10 or 20 percent, but could some clients could have the risk tolerance and liquidity for higher allocations. For other clients, even those that have large portfolios, we might not recommend any private equity finance at all. A one-size-fits-all approach is not appropriate for investment decisions generally, but specially when determining the level of equity finance investment. Individual decisions are essential.

While you need not necessarily follow each step in our process, this will ensure that you have thoroughly considered your investment before you proceed. Ideally, you'll still will have identified an exclusive equity manager with a strong track record and has provided enough transparency so that you are confident the questions you have have been answered and then for any additional concerns will likely be addressed. You should understand the investment's strategy and charges and feel certain its returns happen to be generated by expertise instead of luck. If you are happy to make a sizable investment, you will ideally negotiate favorable terms as opposed to paying rack rates.

They are our goals once we propose a private equity investment to 1 of our clients. Equity finance investing can carry significant risk, but it can still be an appropriate addition to a long-term investment strategy. While our approach doesn't guarantee a fund will offer market-beating returns, it determines that the fund is free of warning signs. We take pride in our due diligence, and we will continue to look for the possiblility to improve our process.