Private Equity For The Hoi Polloi?
The rarefied world of private equity investment is opening up. Until recently, the option of buying stakes in hot companies before they went public was available only to a select few: insiders, institutional investors, and the superrich. But now the merely wealthy--and even average folk--can get in the door as financial-services firms roll out private equity products with lower minimum investments, and mutual funds start to dabble in the sector.
Interest in private equity investing is growing. With people wondering how much longer the stock market's runup can continue, many are looking to diversify the risks of a standard stock portfolio. Average investors also have been watching with envy as venture capitalists pocket billions from Internet and high-tech startups. In the past three years, venture-capital investments have returned an average of 32%, vs. 22.4% for all private equity deals, according to Venture Economics, a division of Thomson Financial Securities Data. After fees, private equity has returned 15% to 20% on average since 1980, vs. 17% for publicly traded stocks.
You can get the most private equity exposure at the least cost with a fund of funds, which pools investors' money to buy into more exclusive private equity funds. Although they require minimum investments of $250,000 and up, that's a fraction of the $10 million to $20 million the private equity funds they invest in want. Brokerages, banks, and other financial-services providers currently offer about 75 private equity funds of funds--double the number that existed three years ago, says Venture Economics. Due to a 1996 federal law change, sponsors have opened the funds to more investors--500 instead of the 100 previously allowed. Now, managers can run parallel funds under both old and new rules, allowing up to 600 combined slots.
Lured partly by fat fees, several mutual-fund companies also are entering the private equity arena. "It was clear to us that we were missing an opportunity," says Steven Spiegel, senior managing director at Putnam Investments, the nation's fourth-largest mutual-fund company. On July 7, Putnam and private equity specialist Thomas H. Lee Co. announced they will jointly launch several funds, possibly including one devoted to Internet companies. Another fund company, Pilgrim Baxter, is also developing a family of private equity funds.
Is a private equity fund of funds for you? Even if you can ante up the minimum, you must be a qualified investor. For funds governed by pre-1996 rules, you need a net worth of at least $1 million. Funds set up under the new law require $5 million in liquid assets, says Robin Painter, a partner in Boston law firm Testa, Hurwitz & Thibeault.
STEEP FEES. You also must be willing to accept steep costs. Whereas the average mutual fund pockets $1.37 of a $1,000 investment, a fund-of-funds manager typically receives 1% of assets plus 5% of the profits. Investors must also pay the underlying funds' fees, which can be as high as a 1% to 3% management fee and 25% of the profits. Most funds also require investors to lock their money up in risky, illiquid stocks for 10 years.
If you can live with these conditions, shop around. These funds come in a variety of styles (table). Some channel money to leveraged buyout firms, which invest in relatively established companies. One example is the Independence Private Equity Select fund, which spreads its $60 million in assets among funds run by renowned LBO firms Apollo Advisors; Hicks, Muse, Tate & Furst; and Clayton, Dubilier & Rice. Jeffrey Gendel, managing director at Independence Holdings Partners, says these three firms have recorded average annual gains of 30% or more. Other funds of funds focus on high-tech venture-capital deals. Whichever fund style you prefer, don't dally. Private investment funds close to new investors when they've raised all the cash they need.
If you can't afford the price of entry into a fund of funds, a small but growing number of mutual funds can give you limited private equity exposure. Under Securities & Exchange Commission rules, they can tie up only 15% of their assets in such illiquid securities.
BARGAIN PRICES. Chip Morris, manager of the T. Rowe Price Science & Technology fund, says many mutual-fund managers are taking serious looks at private Net companies rather than waiting for them to go public at "extreme valuations." Currently, less than 1% of Morris' fund is invested in a private business-to-business E-commerce company, which he declines to name.
Morris is not alone. Growth stock manager Garrett Van Wagoner had about 3% of the assets in two of his funds in private deals as of Dec. 31, when Van Wagoner Funds filed its most recent annual report. One holding was Net sensation iVillage, which subsequently tripled, to 80 1/8, on its first day of trading in March. The Warburg Pincus Post-Venture Capital fund currently has 6% of its $130 million in private companies or venture-capital funds, says Robert Janis, managing director. "We can get mutual-fund investors access to a style of investing that they couldn't do on their own," he says.
Some mutual funds with unusual structures are pursuing private placements even more aggressively. J&W Seligman raised $580 million for a closed-end fund that will invest as much as 35% of its assets in venture-capital funds and fledgling Net and high-tech companies. To be managed by Seligman's tech-stock guru, Paul Wick, the Seligman New Technologies Fund will have a $10,000 minimum and a steep 3% up-front sales charge plus a 3% annual expense ratio. Unlike a regular mutual fund, investors can't withdraw their money anytime; they must wait for the fund's quarterly repurchases of 5% of its shares.
As such, the fund reflects some of the downsides of investing in private placements. But as investors who've gotten in on the ground floor of many high-tech startups have learned, going the private equity route can be lucrative for those with the resources to hang tough.
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