As an alternative investment, private equity is not only a low-correlation play but also a risk/reward speculation.

Just as stocks are generally riskier than bonds and deliver higher returns, small-cap stocks typically are riskier than large-caps while historically producing larger gains. On that continuum, private equity is considered riskier than public equity, as private companies may be smaller and less-scrutinized by regulators than public firms, with negotiated rather than market-set pricing.

Have the higher risks been justified by plumper profits? Apparently so. A recent report from Bain & Co. looked at results through mid-2013 and found that over the latest five-, 10- and 20-year periods “buyout funds consistently beat the PME [public market equivalent] in all regions of the globe.” In the U.S., the annual internal rate of return was 14% for 10 years and 13% for 20 years, topping public equities by about two to one.

BLIND POOLS

Nevertheless, not every private equity fund will produce those stellar returns, and choosing potential winners is by no means simple. “We like transparency,” says Brian Andrew, president and chief investment officer at Milwaukee-based financial services firm Cleary Gull, “but the blind pool concept is prevalent.” That is, many private equity funds raise capital and obtain financial commitments from investors who don’t know how their money will be spent.

If advisors are considering private equity funds for clients, they should have a plan for evaluating blind pools and selecting possible winners. That often means reviewing the past performance of the fund managers to see if they have had success. “You should look beyond the posted gains to see if it’s likely they’ll do as well in the future,” says Andrew. “Validate the investment process to make sure you’re comfortable with the way they’ve made money in the past.”

INVESTMENT PROCESS

To do so, Andrew suggests looking closely at specific transactions the managers have implemented in the past few years. Are the types of companies they bought similar to those this fund will seek? Did prior funds have a high “hit rate” or were the returns boosted by one or two big winners among many disappointments?

“It’s important to see if the managers have a network of management professionals they can call upon, to create value for their portfolio companies,” says Andrew. “For example, a fund manager might have relationships with people on the distribution side of the industry in which they plan to invest. The fund manager may have access to manufacturing experts who could improve production efficiency and increase operating margins. Another possibility is a manager’s ability to bring in logistics professionals who can find ways to squeeze money out of the cost of moving things.”

Andrew says that he sometimes will invest with a manager setting up a new fund, if that individual has had favorable private equity experience elsewhere. “To help raise money,” he explains, “a new fund might be smaller and more transparent, with more focus on making each transaction a success.”

FUND OF FUNDS

Another tactic is to invest in a private equity fund of funds, rather than a single fund. There can be fee duplication but also increased diversification.

“We’ve seen smaller minimum investment requirements, perhaps $500,000, in funds of funds,” says Andrew. “A traditional private equity fund might require $1 million or more.” The smaller minimum may be more acceptable to clients and might allow some to go into more than one fund of funds, increasing the chance of winding up with those impressive overall results posted by private equity in the last two tumultuous decades.

Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.

Donald Jay Korn

Donald Jay Korn is a New York-based financial writer who contributes to Financial Planning and On Wall Street.