Risks and Costs of Investing in Private Equity

Private equity fund investment is guided by restrictions driven by the high levels of risks experienced in private equity investment. Such an investment is generally subject to disclosure in the private equity fund prospectus.

The risks may be categorized as:

• General private equity risk factors.
• Investment strategy-specific risk factors (buyout, venture capital, mezzanine).
• Industry-specific risk factors.
• Risk factors specific to the investment vehicle.
• Regional or emerging market risks.

General Private Equity Risk Factors

Liquidity Risk

Since private equity investments do not trade publicly, it may be difficult to liquidate a position.

Unquoted Investments

Since private equity investments do not have a publicly quoted price, they may be riskier than publicly traded securities.

Competitive Environment Risk

Competition for discovering investment opportunities on attractive terms may be high.

Agency Risk

The managers of private equity portfolio firms may not put the best interests of the private equity firm and those of the investors first.

Risk of Capital

Capital withdrawal creates a likely increase in business and financial risks. Additionally, portfolio firms may find that subsequent rounds of financing are difficult to obtain.

Government Regulatory Risk

The portfolio firms’ products and services may be adversely affected by government regulation.

Taxation Risk

Tax treatment of capital gains, dividends, or limited partnerships may change over time.

Valuation Risk

Valuation of private equity investments is subject to significant judgment. When an independent party does not conduct valuations; they may be subject to biases.

Risk of Diversification

Private equity investments are likely to be poorly diversified. Stockholders should, therefore, diversify across the investment expansion stage.

The Risk of the Market

Private equity is subject to changes in long-term interest rates, exchange rates, and other market risks, while short-term changes are typically not significant risk factors.

Costs Associated With Private Equity Investing

The costs related to investing in private equity are considerably higher compared to those of publicly-traded securities. Such costs include the following:

Transaction Costs

Refer to costs related to due diligence, bank financing, legal fees from acquisitions, and sales transactions in portfolio firms.

Investment Vehicle Fund Set up Costs

Comprises mainly legal costs for the setup of the investment vehicle. Such costs are typically amortized over the life of the investment vehicle.

Administrative Costs

Comprises custodian, transfer agent, and accounting costs. These costs are incurred annually as a fraction of the investment vehicle’s net asset value.

Audit Costs

These are charged annually at a fixed fee.

Management and Performance Costs

These are usually higher than those for other investments. They are mostly a 2% management fee and a 20% fee for performance.

Dilution Costs

Refer to when stock option plans are granted to the management of a portfolio firm and private equity firms, respectively, in a financing round.

Placement Agent Costs

Placement agents whose function is to raise funds for private equity firms may charge 2% advance fees or annual trailer fees as a percentage of funds raised through LPs.

A trailer fee refers to the payment made by the fund manager to the individual selling the fund to investors.

Question

Which of the following is most likely a risk associated with private equity investment?

1. Audit cost.
2. Placement fee.
3. Loss of capital.

Solution

The correct answer is C.

A major capital loss may occur due to the high financial and business risk involved.

A and B are incorrect. These are costs associated with private equity investment.

Reading 38: Private Equity Investments

LOS 38 (f) Explain risks and costs of investing in private equity.