RISK CONSIDERATIONS IN PRIVATE EQUITY FUNDS

By Unifinn Corporate Finance June 5, 2022

8 KEY INVESTMENT RISKS IN PRIVATE EQUITY FUNDS

Are private equity funds high risk? What are the key risks of private equity?

An investment in a private equity fund can involve a high degree of risk. As private equity firms and their portfolio companies continue to perform well, they also face mounting pressure to deliver investor returns and competitive value. Investors are always advised to refer to the confidential private placement memorandum for the specific fund under consideration for a more complete assessment of the risks involved in an investment. These risks may include:

(1) Long-Duration, Illiquid Asset Class
(2) Valuation
(3) Speculative Investment
(4) Commitments to Managers are Long-Term and Binding
(5) Default Remedies
(6) “Blind-Pool” Investing
(7) Access to Timely Information
(8) Schedule K-1 Statements

Key risks in private equity investments.

(1) LONG-DURATION, ILLIQUID ASSET CLASS

Private equity strategies are generally long-term illiquid investments with no organized exchange or public market. Partnerships can last 10-15 years. Unlike common stock in a publicly held corporation, investors cannot readily liquidate private equity investments. Furthermore, the secondary market for these types of investments is often limited, and secondary bids for partnership units may occur at steep discounts to reported net asset values. Many of the advantages of private equity can only be exploited over time. Investors in the asset class should be able and willing to make a long-term commitment to reap the rewards of their investment.

(2) VALUATION

As private equity funds generally will invest in securities that are not readily marketable, the current fair market values are very often difficult to ascertain. The industry has evolved significantly over the past several years following the requirements laid out by the Financial Accounting Standards Board (“FASB”). Beginning in 2007, financial statements had to reflect the “fair value” of assets as of the reporting date. The fair value was defined within FASB literature as the price at which a willing buyer and a willing seller would conduct a transaction for the asset. Even with the additional requirements, determining fair value is subjective, and general partners may often take different approaches to estimate it. However, through demands from the investor base and industry pressure, the transparency and disclosure around fair value are much improved from years past.

(3) SPECULATIVE INVESTMENT

The investment strategies used may include highly speculative investment techniques, highly concentrated portfolios, control and non-control positions and illiquid investments. Because of the specialized nature of private equity, the investment is not suitable for certain investors, and, in any event, an investment in a private equity fund should constitute only a limited part of an investor’s total portfolio. There can be no assurance that a private equity investment will return investors’ capital or that cash will be available for distributions.

(4) COMMITMENTS TO MANAGERS ARE LONG-TERM AND BINDING

Once a commitment is made to a private equity manager, that commitment is legally binding through the terms of the limited partnership agreement. Even if a fund manager is performing poorly, limited partners must still honour their capital commitments. Limited partners in a fund generally cannot fire or replace a manager who is performing poorly, and their recourse may be limited. When managers are performing poorly or are not investing in accordance with their stated strategy, investors may seek to influence the fund’s investment strategy and direction through ongoing dialogues, organized forums such as fund advisory boards and/or their contractual rights as outlined by the limited partnership agreement of the particular fund. Nonetheless, this can be a difficult process. The difficulty or inability of investors to replace underperforming managers underscores how important it is for investors and advisers alike to perform comprehensive manager due diligence before investing.

(5) DEFAULT REMEDIES

If an investor fails to fund a capital call from a private equity fund, the fund may exercise various remedies with respect to such an investor and its interest. These remedies include but are not limited to, causing the investor to forfeit or sell all or a portion of its interest in such fund, or requiring the investor to pay up to the full amount of its remaining capital commitment.

(6) “BLIND-POOL” INVESTING

When committing to a private equity fund, an investor is essentially committing to a team of professionals, since in many cases private equity is “blind-pool” investing (i.e., the investor does not know the composition of the portfolio because funds are raised first and thereafter invested in portfolio companies). “Blind-pool” investing underscores the importance of conducting thorough and rigorous manager due diligence before making an investment.

(7) ACCESS TO TIMELY INFORMATION

Typically, a three-month time lag may occur between the end of a quarter and when investors in a private equity fund receive their quarterly report. This time lag is primarily a result of the number of discrete portfolio companies in which a manager invests and the associated financial reporting that goes along with each investment. In certain cases, depending on the policy of the individual manager, it may be difficult to obtain detailed financial information for individual portfolio holdings. Many private equity firms believe in closely guarding the confidentiality of their investments. If certain sensitive financial information were made broadly available, it could put their portfolio companies at a competitive disadvantage.

(8) SCHEDULE K-1 STATEMENTS

IRS Schedule K-1 statements provide the information that taxable US investors need to file their personal tax returns. Given the number of underlying portfolio investments and the complexity involved in preparing these tax schedules, Schedule K-1 statements are likely to be received by investors after the April 15 tax-filing deadline. Therefore, it is not uncommon for investors in private equity partnerships to have to file for an extension. In addition, depending on the structure of certain investments within the partnership, the potential exists for multi-state tax filings for investors. Some fund managers (especially funds of funds) will provide tax projections to investors in advance of Schedule K-1 statements, to assist with tax planning.