When a process is working, conventional wisdom suggests leaving it alone. If it isn’t broken, why fix it?
At Palisades Hudson, though, we would rather devote extra energy to making a good process great. Instead of resting on our laurels, we have spent the last few years focusing on our private equity research, not because we are dissatisfied, but because we believe even our strengths can become stronger.
We have been evaluating private equity investments for our clients from the inception of Palisades Hudson Asset Management in 1997. Since I became chief investment officer of Palisades Hudson in 2012, the Investment Committee and I have taken a variety of steps to build upon and improve our research and due diligence processes.
As an investor, then, what should you look for when considering a private equity investment? Many of the same things we do when considering it on a client’s behalf.
Private Equity 101: Due Diligence Basics
Private equity is, at its most basic, investments that are not listed on a public exchange. However, I use the term here a bit more specifically. When I talk about private equity, I do not mean lending money to an entrepreneurial friend or providing other forms 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 held companies.
Before researching any private equity investment, it is crucial to understand the general risks involved with this asset class. Investments in private equity can be illiquid, with investors generally not allowed to make withdrawals from funds during the funds’ life spans of 10 years or more. These investments also have higher expenses and a higher risk of incurring large losses, or even a complete loss of principal, than do typical mutual funds. In addition, these investments are often not available to investors unless their net incomes or net worths exceed certain thresholds. Because of these risks, private equity investments are not appropriate for many individual investors.
For our clients who possess the liquidity and risk tolerance to consider private equity investments, the basics of due diligence have not changed, and thus the foundation of our process remains the same. Before we recommend any private equity manager, we dig deeply into the manager’s investment strategy to make sure we understand and are comfortable with it. We need to be sure we are fully aware of the particular risks involved, and that we can identify any red flags that require a closer look.
If we see a deal-breaker at any stage of the process, we pull the plug immediately. There are many quality managers, so we do not feel compelled to invest with any particular one. Any questions we have must be answered. If a manager gives unacceptable or unclear replies, we move on. As an investor, your first step should always be to understand a manager’s strategy and ensure that nothing about it worries you. You have plenty of other choices.
At Palisades Hudson, we prefer managers who generate returns by making significant operational improvements to portfolio companies, rather than those who rely on leverage. We also research and evaluate a manager’s track record. While the decision about whether to invest should not be based on past investment returns, neither should they be ignored. On the contrary, this is among the biggest and most important pieces of data about a manager that you can easily access.
We also consider each fund’s “vintage” when evaluating its returns. A fund that began in 2007 or 2008 is likely to have lower returns than a fund that began earlier or later. While the fact that a manager launched previous funds just before or during a down period for the economy is not an instant deal-breaker, take time to understand what the manager learned from that period 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 current fund to be structured, specifically how diversified the portfolio will be. How many portfolio companies does the manager expect to own, for example, 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. Investors’ risk tolerances vary, but all should understand the amount of risk an investment involves before taking it on. If, for example, a manager has done a poor job of constructing portfolios in the past by making large bets on companies that didn’t pan out, be skeptical about the likelihood of future success.
As with all investments, one of the most important factors in evaluating private equity is fees, which can seriously impact your long-term returns. Most private equity managers still charge the typical 2 percent management fee and 20 percent carried interest (a share of the profits, often above a specified hurdle rate, that goes to the manager before the remaining profits are divided with investors), but some may charge more or less. Any manager who charges more had better give a clear justification for the higher fee. At Palisades Hudson, we have never invested with a private equity manager who charges more than 20 percent carried interest. If managers charge less than 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 your time. Our process is thorough and deliberate. Be sure that you understand and are comfortable with the fund’s internal controls. While most fund managers will not get a sniff of interest from investors without strong internal controls, some funds can slip through the cracks. Watch out for funds that do not provide annual audited financial statements or that cannot clearly answer questions about where they store their cash balances. Feel free to visit the manager’s office and ask for a tour.
The more or less open secret in the private equity industry is that everything is negotiable. See if you can negotiate lower fees or, if you want it, a reduced minimum commitment. At private equity’s peak in 2006 and 2007, managers had all the leverage, so negotiating with them was difficult. Now the tables have turned, and it can be much easier to set up an investment on your own terms, especially for investment managers and institutional investors, but to a lesser extent for individuals as well.
Next Steps: Going Above And Beyond
Times change. While the fundamentals remain largely the same, private equity is an industry like any other, which means that new schools of thought and different approaches arise. We make a point of staying current with trends and issues in the industry.
The tools and data available to advisers have improved, and while more information can ultimately make our jobs easier, it is still up to us — as it is to investors performing their own due diligence — to make the best use of the data. For example, when our Investment Committee evaluates a private equity manager, we now look for managers who follow similar strategies so we can compare them. Even if a manager passes all of our tests, we find that it is still worth looking at other managers to see how they compare.
One particular item of data that has become easier to find is how much of a manager’s investment return was attributable to the manager’s expertise and operational improvements to portfolio companies and how much to the macroeconomic environment or leverage. Some managers may not be able or willing to provide this information, but for those who are, it can be very helpful in providing a clear measure of how much value a manager added.
We also have created formal procedures to ensure that our client private equity portfolios are diversified by strategy and vintage. We do not have a maximum that we recommend for any one strategy or vintage, because each client has different goals and risk tolerance. But by adding this step and keeping an eye on diversification in a disciplined way, we seek to generate higher returns and lower risk over the long term.
We have also devoted more time to considering each client’s target private equity allocation. In the past, we may have recommended a maximum 10 or 20 percent, but we realize some clients may have the risk tolerance and liquidity for higher allocations. For other clients, even those with large portfolios, we may not recommend any private equity at all. A one-size-fits-all approach is not appropriate for investment decisions generally, but especially when determining the level of private equity investment. Individual decisions are required.
While you need not necessarily follow every step in our process, doing so will ensure that you have thoroughly considered your investment before you proceed. Ideally, in the end you will have identified a private equity manager who has a strong track record and has provided enough transparency so you are confident your questions have been answered and any additional concerns will be addressed. You should understand the investment’s strategy and fees and feel sure that its returns have been generated by expertise and not luck. If you are willing to make a sizable investment, you will ideally negotiate favorable terms rather than paying rack rates.
These are our goals whenever we propose a private equity investment to one of our clients. Private equity investing can carry significant risk, but it can still be an appropriate addition to a long-term investment strategy. While our approach does not guarantee a fund will offer market-beating returns, it determines that the fund is free of red flags. We take pride in our due diligence, and we will continue to look for opportunities to improve our process.