By Tim Dulaney, PhD, FRM and Tim Husson, PhD
Brendan Conway over at Barron's pointed out an interesting new study (PDF) from the National Bureau of Economic Research entitled: Valuing Private Equity. Private Equity (PE) investments -- typically called limited partnerships (LPs) -- are long-term, illiquid securities representing (perhaps not surprisingly) an equity interest in a private company. Investors are typically referred to as limited partners. The study notes that while private equity returns tend to be high, "it remains controversial whether this outperformance is sufficient to compensate investors (LPs) for the costs of risks and long-term illiquidity."
Typically, a PE equity firm manages the investment and serves as a general partner (GP) -- collecting annual management fees of 1%-2% as well as incentive fees of around 20% of the profits.1 In principle, such incentive fees are meant to increase the returns investors will realize, but with increasing returns comes increasing risk.
The authors of Valuing Private Equity argue that the GP "must generate sufficient risk-adjusted excess return" to compensate the LP for bearing the liquidity risk and performance fees. The authors find that the illiquidity of PE investments is as large of a cost to LPs as total GP compensation. In particular, the study finds that "LPs may just break even, net of management fees, carry, risk, and costs of illiquidity." PE investments carry significant risk for potential LPs and any investor considering such an investment should fully weigh the cost of illiquidity and GP compensation.
These findings are particularly interesting given that several new retail investments are targeting private equity or private equity-like allocations. Brendan's article mentions the PowerShares Global Listed Private Equity Portfolio (PSP) exchange-traded fund, but non-traded business development companies (BDCs) also invest in high risk ventures, such as emerging or distressed companies. Retail investors should therefore familiarize themselves with the risks of private equity investing before considering such strategies.
1Incentive fees are sometimes referred to as "carried interest" in PE.
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