{"id":23786,"date":"2021-11-24T10:09:48","date_gmt":"2021-11-24T10:09:48","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=23786"},"modified":"2023-01-03T10:09:40","modified_gmt":"2023-01-03T10:09:40","slug":"risks-and-costs-of-investing-in-private-equity","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/risks-and-costs-of-investing-in-private-equity\/","title":{"rendered":"Risks and Costs of Investing in Private Equity"},"content":{"rendered":"<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/qw-HAUAz7Vw\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\r\n<p>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.<\/p>\r\n<p>The risks may be categorized as:<\/p>\r\n<ul>\r\n\t<li>General private equity risk factors.<\/li>\r\n\t<li>Investment strategy-specific risk factors (buyout, venture capital, mezzanine).<\/li>\r\n\t<li>Industry-specific risk factors.<\/li>\r\n\t<li>Risk factors specific to the investment vehicle.<\/li>\r\n\t<li>Regional or emerging market risks.<\/li>\r\n<\/ul>\r\n<h2>General Private Equity Risk Factors<\/h2>\r\n<h4>Liquidity Risk<\/h4>\r\n<p>Since private equity investments do not trade publicly, it may be difficult to liquidate a position.<\/p>\r\n<h4>Unquoted Investments<\/h4>\r\n<p>Since private equity investments do not have a publicly quoted price, they may be riskier than publicly traded securities.<\/p>\r\n<h4>Competitive Environment Risk<\/h4>\r\n<p>Competition for discovering investment opportunities on attractive terms may be high.<\/p>\r\n<h4>Agency Risk<\/h4>\r\n<p>The managers of private equity portfolio firms may not put the best interests of the private equity firm and those of the investors first.<\/p>\r\n<h4>Risk of Capital<\/h4>\r\n<p>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.<\/p>\r\n<h4>Government Regulatory Risk<\/h4>\r\n<p>The portfolio firms\u2019 products and services may be adversely affected by government regulation.<\/p>\r\n<h4>Taxation Risk<\/h4>\r\n<p>Tax treatment of capital gains, dividends, or limited partnerships may change over time.<\/p>\r\n<h4>Valuation Risk<\/h4>\r\n<p>Valuation of private equity investments is subject to significant judgment. When an independent party does not conduct valuations; they may be subject to biases.<\/p>\r\n<h4>Risk of Diversification<\/h4>\r\n<p>Private equity investments are likely to be poorly diversified. Stockholders should, therefore, diversify across the investment expansion stage.<\/p>\r\n<h4>The Risk of the Market<\/h4>\r\n<p>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.<\/p>\r\n<h2>Costs Associated With Private Equity Investing<\/h2>\r\n<p>The costs related to investing in private equity are considerably higher compared to those of publicly-traded securities. Such costs include the following:<\/p>\r\n<h4>Transaction Costs<\/h4>\r\n<p>Refer to costs related to due diligence, bank financing, legal fees from acquisitions, and sales transactions in portfolio firms.<\/p>\r\n<h4>Investment Vehicle Fund Set up Costs<\/h4>\r\n<p>Comprises mainly legal costs for the setup of the investment vehicle. Such costs are typically amortized over the life of the investment vehicle.<\/p>\r\n<h4>Administrative Costs<\/h4>\r\n<p>Comprises custodian, transfer agent, and accounting costs. These costs are incurred annually as a fraction of the investment vehicle\u2019s net asset value.<\/p>\r\n<h4>Audit Costs<\/h4>\r\n<p>These are charged annually at a fixed fee.<\/p>\r\n<h4>Management and Performance Costs<\/h4>\r\n<p>These are usually higher than those for other investments. They are mostly a 2% management fee and a 20% fee for performance.<\/p>\r\n<h4>Dilution Costs<\/h4>\r\n<p>Refer to when stock option plans are granted to the management of a portfolio firm and private equity firms, respectively, in a financing round.<\/p>\r\n<h4>Placement Agent Costs<\/h4>\r\n<p>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.<\/p>\r\n<p>A trailer fee refers to the payment made by the fund manager to the individual selling the fund to investors.<\/p>\r\n<blockquote>\r\n<h2>Question<\/h2>\r\n<p>Which of the following is most likely a risk associated with private equity investment?<\/p>\r\n<ol style=\"list-style-type: upper-alpha;\">\r\n\t<li>Audit cost.<\/li>\r\n\t<li>Placement fee.<\/li>\r\n\t<li>Loss of capital.<\/li>\r\n<\/ol>\r\n<h4>Solution<\/h4>\r\n<p><strong>The correct answer is C.<\/strong><\/p>\r\n<p>A major capital loss may occur due to the high financial and business risk involved.<\/p>\r\n<p><strong>A and B are incorrect.<\/strong>\u00a0These are costs associated with private equity investment.<\/p>\r\n<\/blockquote>\r\n<p>Reading 38: Private Equity Investments<\/p>\r\n<p><em>LOS 38 (f) Explain risks and costs of investing in private equity.<\/em><\/p>\r\n<ol><\/ol><!-- \/wp:post-content -->","protected":false},"excerpt":{"rendered":"<p>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:&#8230;<\/p>\n","protected":false},"author":4,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[562,102],"tags":[],"class_list":["post-23786","post","type-post","status-publish","format-standard","hentry","category-alternative-investments","category-cfa-level-2","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.9 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Risks and Costs of Investing in Private Equity - CFA, FRM, and Actuarial Exams Study Notes<\/title>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/risks-and-costs-of-investing-in-private-equity\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Risks and Costs of Investing in Private Equity - CFA, FRM, and Actuarial Exams Study Notes\" \/>\n<meta property=\"og:description\" content=\"Private equity fund investment is guided by restrictions driven by the high levels of risks experienced in private equity investment. 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