Private equity has traditionally been an asset class reserved for mega investors with long-term investment horizons and an ability to have funds locked up for up to 10 years at a time. These investors have traditionally included big pension funds, endowments, Sovereign Wealth Funds, foundations, and family offices.
In return for being able to write big cheques (+$25m) and having their funds locked up for long periods of time, they have often earned superior IRR’s in comparison to other asset classes. They still face challenges though – the committed but uncalled capital problem. Private equity consists of a limited partnership between Limited Partner funders (LPs) and the General Partner (GP), who manages the fund. The GP raises funds from LPs,in the form of commitments, then goes out to find companies to buy, conducts due diligence, and negotiates the deal to buy the companies. During this process, which may take up to 4 years to deploy the whole fund, an LP is committed, and must have funds ready to wire to the GP when called for, but until it is “called”, it is sitting idle not earning much of a return. So LPs have long needed a solution for their committed but uncalled capital.
Issues faced by smaller investors wanting to invest in private equity
Historically, there are three main challenges faced by smaller investors, which prevents them from investing in private equity:
- Illiquidity of private markets – private equity includes buying and holding unlisted private companies for several years at a time. This is unlike holding public listed shares which can be sold in an instant, returning the investment.
- Minimum investment requirements – private equity funds typically have minimum fund subscription sizes, such as $25m, which means this asset class is out of reach for most individual investors.
- Vintage risk – simply put, this is the risk that the year an investor makes an investment in a PE fund, it coincides with high valuations of companies, resulting in poor IRRs for the fund. The reverse may also be true, providing upside. Pension funds can avoid this risk, since they are constantly investing funds over different vintages and strategies, whereas it is more difficult for individuals to manage, since they may only be able to make one investment, for example after having received a windfall from sale of a business, rather than using the process of dollar-cost averaging into publicly quoted companies.
As a result of these challenges explained above, a new trend is emerging in private equity fundraising, to attract capital from retail investors, in amounts as low as USD 25,000. In fact, I recently met with a private equity collectives group which was taking subscriptions as low as GBP 10,000 per investor.
Some of the well-known private equity managers offering these services, include KKR’s K-Prime, Apollo’s AAA, and Blackstone’s BXPE. According to a recent article by the FT, these funds have raised $5bn in 2023, and there are about 4,000 such funds, looking to raise an aggregate of $1.2 trillion.
Different types of funds
The private equity industry has created three main fund investing options for retail investors, including 3rd party evergreen funds, 1st party open ended funds, and private wealth manager feeder funds.
- 3rd party evergreen funds
As the name evergreen suggests, these types of funds don’t have an end date. This contrasts with a private equity closed ended fund, which usually has a 10 year life, after which time the investors get their money back. Evergreen funds invest in many different types of PE funds, either as primary funds, direct co-investments alongside PE funds, or secondaries. Examples of the main third party evergreen funds include Hamilton Lane, Northleaft, Partners Group and Harbourvest.
Evergreen funds often have the following characteristics
- Methods – Secondaries, Direct Co-investments, and primaries
- Stages – Venture Capital, growth and buyout
- Geographies – North America, Europe, and Asia
Evergreen funds are targeted at individual investors because they offer solutions for the challenges typically faced by these investors, including:
- They have low minimum investment requirements at around USD25,000;
- They are semi-liquid. This means an investor may redeem their investment on either a monthly or quarterly basis, but subject to redemption gates, such as 5% of NAV per quarter. However, there is usually a lock up period of 3 years in these funds, which means investor can’t withdraw their funds for this period of time else there will be significant penalties.
The semi-liquid nature of these funds have led to a wave of innovating financing mechanisms, to ensure funds have liquidity to meet redemptions, such as NAV financing and SLOCs, which I will touch on in later posts.
Private equity fund managers however, still need to ensure that these retail funds are not left uninvested for long periods of time, else this can cause “cash drag” which lowers investors returns. Different fund managers have different strategies here. For example, Blackstone will put a small share of every new deal it strikes into the BPXE vehicle, whereas KKR has started to shift slices off existing deals into its K-Prime product, thus enabling these funds to have access to various vintages and staggered exits.
Nothing is perfect though, as even these strategies come with the potential for conflict of interest, such as the selection and valuation of these illiquid assets. In addition, will be the discount from NAV necessary on sale of the investment.
2. 1st party open-ended fund
1st party funds means these private equity funds offer products they have created, for example KKR has a product called K-Plan whilst EQT has a product called EQT-Nexus, rather than investing in 3rd party products.
The products are structured in a similar way to 3rd party evergreen funds in that they have a mix of stages (VC, growth, buyout), sectors, and geographies. And they have similar semi-liquid status, offering frequent subscriptions and redemptions, subject to a lock up period and redemption gates.
3. Private wealth channels such as feeder funds
In the past, wealth managers have tried to give clients the option to invest in private equity, through a pooled fund, which groups clients capital together, to enable it to have the minimum capital to access PE funds.
However new digital investment products have been created as the industry has evolved, to streamline the process by which wealth managers can invest their clients money into PE. These include Moonfare’s Permira, KKRs Cygnus, and Opto, which is managed by former CPP CEO, Mark Machin. Opto is a technology platform which creates feeder funds, enabling RIAs to invest on behalf of its clients in its private equity funds.
Conclusion
This is an exciting time for individual investors, who may have $25,000 to invest in a product, which could get them an annualised internal rate of return of 20% or more, over a period of time, which is well in excess of other asset classes. It enables investors from all around the world, to invest in some of the most exciting and innovative private companies of our time, thus diversifying their assets away from their own countries, and away from the volatility of public markets.
However a few things to note, include:
- It is necessary to conduct due diligence on the private equity manager, compared to investing in a S&P 500 index fund;
- You will need to be comfortable with a lock up period of 3 years, before being able to redeem your investment. Even then, there are redemption gates to consider, meaning you may not be able to sell all your investment in one particular quarter
- Your return will almost always be lower than the IRR quoted by the fund manager, because of the uncalled capital problem, when your money has not yet been put to work.