November 1, 2000

Going Private

While not for everyone, private equity can be a lu

High fees, long-term capital commitments, varying performance measurements, and a lack of liquidity. Doesn't exactly sound like the ideal asset class to add to your wealth management practice.

But a growing number of financial planners with exceptionally high-net-worth clients are adding private equity to their services despite these nettlesome characteristics. Furthermore, the stimulus is often provided not by advisors' own enthusiasm, but by their entrepreneurial clients who have made fortunes with private equity backing.

"Frankly, it's hard to take a guy who's sold his company for 14 times investment and say we're hoping to get 9% a year for you," confides Mary MacLachlan, president of New York-based EnvestNet Advisory Group, a full-service advisory firm. "The most sensible way around that disconnect is to explain the risks of private equity. Then, if people still want to take a shot, that's fine."

Whatever the risks, private equity has been all the rage over the past decade, with fundraising commitments in the US alone rising from $8 billion in 1991 to an estimated $110 billion for 2000, according to Asset Alternatives. In part, this increase has been fueled by institutional and individual investors seeking the stellar returns of top buyout firms in the late 1980s and, more recently, the atmospheric returns of numerous venture capital firms in the past five to eight years.

Buyout (sometimes called "corporate finance") funds and venture capital account for 90% of private equity capital raised and invested in the United States. Venture capitalists generally invest in young companies with a technological bent. By contrast, buyout funds have traditionally targeted undervalued cash flow and/or restructuring opportunities in larger businesses, frequently within mature industries. Yet both venture and buyout firms do share an emphasis on long-term, often multi-round capital commitments, strategic and management input alongside capital infusion, and a common investment structure - the private limited partnership.

Limiting Limited Partners

Consequently, the SEC does have a few things to say about who is eligible to invest in private equity through these partnership vehicles. Before 1997, only a total of 99 "accredited investors" (individuals with at least $1 million in investable assets; institutions with $5 million) were permitted as limited partners within these largely unregulated partnerships. But since enactment of the National Securities Market Improvement Act (NSMIA) in 1997, up to 499 "qualified purchasers" (individuals with $5 million; institutions with $25 million) may participate. Along with other developments, this amendment has stimulated greater private equity involvement by institutional and individual investors alike.

Ironically, however, private equity does pose complications to the same high-net-worth individuals who are so anxious to invest in the asset class.

First, on the buyout side, exceptionally high investment minimums can be required - $10 million or even $20 million per limited partner.

Second, over the past few years, well-established venture capital firms have been awash with capital from existing investors, and thus inaccessible to new individuals or families.

Third, private equity is a young, largely unregulated corner of the capital market.

Fourth, diversification among managers is highly desirable to those with tepid risk tolerance. "Top quartile" private equity managers have solidly outperformed public markets over 5- and 10-year periods, but there remains a gaping chasm between top and bottom quartile performance.

Comparing Morningstar and Venture Economics data, mutual funds showed a 12% gap between top and bottom quartile managers for a recent 10-year interval (through 1998), while buyout funds had a 20% gap and venture funds a 30% disparity. "Unless you hit that top quartile of performance," admits Mark Spangler of Spangler Financial Group in Seattle, "you may be wasting your time in private equity."

The Funds-of-Funds Phenomenon

For many of the reasons above, one of the fastest growing segments within private equity has been in the funds-of-funds arena. As in the hedge fund world, private equity funds of funds aggregate institutional and high-net-worth capital for investment into a diversified portfolio of private equity funds, which then invest in a larger, presumably broader selection of portfolio companies.

As exhibit 1 (see above) indicates, the diversification provided by funds of funds can be of numerous kinds. First, investment is diversified among several private equity managers, each of whom will have a different strategy or focus. The end result is that the funds-of-funds investor can achieve diversification in geography (e.g., U.S. and foreign portfolio companies), industry, investment stage, and also time horizon, as some investments are made in the first year of the vehicle, others not until years two, three, or four.

Recent growth in this market has been nothing short of astonishing. As Exhibit 2 (below) indicates, the number of funds of funds raised on a global basis doubled from 1997 to 1999, with a 10-fold increase in dollar commitments. Just as important, much of the demand-side growth in funds of funds has come from the high-net-worth market (see chart on page 66). Much of the recent supply-side growth has come from firms with a ready base of high-net-worth investors, such as investment or commercial banks.

One of the first firms to sense the now-evident logic of funds of funds for high-net-worth individuals and families was FLAG Venture Management. Founded in 1995 by family office manager Peter Lawrence and venture capitalist Diana Frazier, FLAG crystallized around the idea that high-net-worth investors needed renewed access to top-tier venture capital firms. Ironically, it was individual and family investors who had helped jump-start the U.S. venture capital industry decades earlier. But, in the wake of ERISA relaxation in the late 1970s, large institutions roared into venture capital, marginalizing high-net-worth investors. "Access became the biggest problem," recalls FLAG's Lawrence. "Most of the top venture firms simply dropped families. It was so much easier to go to AT&T or Yale and take out $20 or $25 million rather than the same total from 10 different families."

In response, FLAG has raised a series of venture-oriented funds of funds from 1995 to the present, with $1.6 billion in total capital under current management. Investment minimums per fund have tended toward the $3 million mark. So FLAG's clientele is clearly at the upper end of the high-net-worth scale, with $100 to $200 million in total assets, and 5% to 20% allocations to venture capital.

On the investment front, FLAG has successfully cemented relationships with highly respected venture firms such as Accel Partners, Mayfield Fund, Oak Investment Partners, and Sequoia Capital. "When it comes to venture," observes Lawrence, "it truly is 99% access. The venture firms with developed franchises have networks other people don't have. They can hire leading managers from top firms for their portfolio companies, which clearly sets them apart."

Similar to FLAG initiatives in the venture arena, New York-based Auda Advisors ($1.6 billion under management) has evolved from a single-family office to an established funds-of-funds manager with a buyout orientation. Aggregating commitments of at least $2 million from limited partners, Auda has invested a series of funds of funds in brand-name buyout firms, such as Thomas Lee Company, and Bain Capital. As noted, the traditional obstacle to individual investment in buyouts has not been restricted access, but rather high investment minimums of $15 or $25 million. And, while Auda investors are decidedly high net worth (averaging $50 million in assets), it is difficult for even these wealthy investors to make reasonable allocations while performing manager due diligence and achieving diversification.

Not Without Costs

Yet, just as the term funds of funds doesn't exactly trip off the tongue, the associated investment and distribution processes can be complex and cumbersome, not to mention expensive.

Consider: Limited partners commit to funds of funds who commit to general partners who in turn invest in portfolio companies... On the rebound, a portfolio company IPO or strategic sale produces liquidity distributed back to the general partner (who, in addition to a management fee, takes a share of profits or "carried interest"), then back to the fund-of-funds manager (who, in addition to a management fee, may also take a carried interest)...

And therein lies perhaps the most irksome rub of funds-of-funds investment - the double layer of fees. Limited partners normally pay a management fee to both the funds of funds and underlying partnership managers. Furthermore, general partners of underlying venture or buyout funds command a 20% or even 25% take of the "carried interest" or investment profits. In addition, some funds-of-funds managers also charge a small "carry" (5%, on average), though normally in conjunction with a "preferred return" that first distributes a pre-specified return on investment (commonly, 8%) prior to imposition of the carry.

Thoroughly confused? Understandably. But the important point is simply that funds of funds can be very expensive investments. In fact, a model recently constructed by Cincinnati-based Fund Evaluation Group, an investment consulting firm, estimated that, given a 20% gross internal rate of return (IRR), a conventional fund-of-funds fee structure on top of typical GP fees could reduce net IRR by 500 basis points to 15% per annum. Thus an investment that initially exceeds historical stock market performance could be reduced to comparable levels of return.

Recently, many private equity funds of funds have achieved substantially higher than 20% gross IRRs. And while dollar-weighted IRRs are not directly comparable to dollar-weighted stock market returns, the fundamental questions remain: How successful can funds of funds managers be in selecting top-quartile GPs who outperform the public markets? And will funds-of-funds investors be sufficiently compensated for these long-term, illiquid investments?

Strategy & Tactics

These questions are particularly salient for investment advisors contemplating private equity for their high-net-worth clients, yet concerned about the layering of fees. One solution proposed by EnvestNet's MacLachlan is that as a financial planning firm takes over marketing and investor relations from private equity managers, this cost component is cut out from the typical management fee. "At Envestnet, we then charge the difference to our client, who will never pay more going through us than if investing directly." While even a year ago it might have seemed quixotic to propose that high-flying private equity firms reduce their fees, it is possible in this new climate of moderating returns and tighter fundraising that Envestnet's shared-fee proposition may find more takers.

Craig Martin of San Jose, California-based Family Wealth Consulting Group often starts his private equity-minded clients with funds of funds as the safest, most diversified methodology. But soon after he starts discussing how clients might invest directly in either venture GP funds or startup companies themselves, while staying within their risk tolerance. Martin readily admits his connections within Silicon Valley make these options more viable for him than for most planners. He also concedes that "if clients don't have at least $2 million to $3 million in investable assets, then injecting 25% into private equity is pure folly."

Similarly, Ballentine, Finn & Company of Wolfesboro, New Hampshire, generally directs more client money into GP funds, rather than funds of funds. Ballentine, Finn's Greg Van Slyke says his firm helps entrepreneurial clients unwind concentrated stock positions and formulate efficient, diversified portfolios. "We do have some clients who, given the risks, just don't care if private equity might marginally enhance their wealth," says Van Slyke. "On the other hand, if you do have other clients with assets as large as ours who want growth while managing volatility, I don't know how you can't consider private equity. At least, you have to ask, how is the private equity investment going to correlate?"

Pondering Portfolios

In fact, the issue of how readily modern portfolio theory (MPT), with its emphasis on asset correlation, can be applied to alternative assets, such as private equity, is hotly debated. MPT emphasizes not simply the return potential of a set of investments, but their relative price movements, or correlation.

Private Equity: A Glossary

Carried Interest the general partner's share of the profits generated through a private equity fund. The carried interest, rather than the management fee, is designated to be the general partner's chief performance incentive. A 20% carried interest - meaning the remaining 80% reverts to the limited partners - is the norm.

Co-investor By having co-investment rights, a limited partner in a fund can invest directly in a company also backed by the fund managers. In this way, the limited partner might end up with two separate stakes in the company: one, indirectly, through the private equity fund; another, through a direct investment.

Distributions Cash or stock returned to the limited partners after the general partner has exited from an investment. The partnership agreement governs the timing of distributions to the limited partner, as well as how any profits are divided among limited partners and the general partner.

Fund of funds A private equity fund that is distributed among a number of other private equity fund managers, who in turn invest the capital into portfolio companies. Funds of funds often give individual limited partners access to funds from which they would otherwise be excluded.

General partner In addition to being used as a title for top-ranking partners at a private equity firm, general partner is used to distinguish the firm managing the private equity fund from the limited partners, the individual or institutional investors who contribute to the fund.

Management fee This annual fee, typically a percentage of limited partner commitments to the fund, is meant to cover the fund's basic administration costs. Management fees run between 1.5%-2.5% for venture and buyout partnerships, and 0.5%-1.0% for funds of funds.

Portfolio company A company in which a venture capital or buyout firm invests.

Source: Asset Alternatives' Private Equity Primer, www.assetnews.com.

The problem with private equity is not only how to compare expected returns with public markets, but also how to measure this volatility or risk. Standard deviation is the conventional measurement for volatility - essentially, how much investment return deviates from its long-term average. But how directly can the standard deviation of illiquid investments, such as private equity (where values don't deviate until financing or liquidity events), be compared to the standard deviation of liquid, tradable assets, such as stocks and bonds? Similarly, the correlation between venture-oriented private equity and public stock markets has clearly increased in recent years. So, on these and other portfolio-related issues, the jury is still out.

For David Diesslin, a Fort Worth, Texas-based investment advisor with both accredited and super-accredited clients, the asset correlation question is largely academic. "Our job as advisors is to make certain that a critical financial mass providing peace of mind is taken care of," Diesslin emphasizes. He is also careful to ensure that clients have not only the necessary risk tolerance in their asset base, but the appropriate "mindset" for private equity's long periods of illiquidity - historically, on the order of three to five years per portfolio company.

Prerequisites established, Diesslin recommends not more than 5% of investable assets in private equity. Admittedly drawn into private equity by his entrepreneurial clients, Diesslin now admits to enjoying the ride. "It's a fun proposition. In fact, I'd say we mainly invest in private equity for fun, intrigue, but also some surprising outcomes in fostering relationships."

Nor is Diesslin's story unique. Many private equity investors, both institutional and high net worth, speak of gradually moving up the "learning curve" from funds of funds, to general partnership investments, and ultimately to some direct "co-investments" into unlisted companies, opportunities which often arise from general partnership relationships. In the process, these investors do venture further out along the risk-return curve, but they also move down the fee scale. And, in the process, they clearly gain insight into these relatively long-term, value-creating investments that intuitively excite today's entrepreneurial high-net-worth investors.

"Venture capital is probably inappropriate for 99 percent of all investors," admits EnvestNet's MacLachlan, former head of the Private Client Group at Global Asset Management, the London-based investment advisor. Yet, having said that, MacLachlan emphasizes that the Prudent Investor Rule expects fiduciaries to consider all investment tools available, including venture, buyouts, and other private equity vehicles. "I'm neither for nor against private equity for my clients. But, as an asset class, it has certainly been an interesting one."

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