The multibillion-dollar leveraged buyout deals have been coming fast and furious in the past few months, each bigger than the last. Amid the frenzy, the titans of private equity such as Blackstone Group, Thomas H. Lee Partners, and Texas Pacific Group reloaded their coffers with new funds of as much as $15 billion. Overall, fund-raising reached a record of more than $215 billion last year, according to Dow Jones Private Equity Analyst.
Now Wall Street has come up with a few twists to open up private equity—previously restricted to institutions and wealthy individu-als who can meet the $10 million to $25 million minimum investments—to the merely affluent. By pooling money from many, some new funds offer buy-ins for as little as $250,000. Then, for diversification, the organizers divvy up the fund's millions among 5 to 10 private equity managers.
The allure of private equity comes from its stellar returns. From 1980 through 2005, private equity returned almost 18% a year, vs. 11% for the Standard & Poor's 500-stock index and less than 8% for 10-year Treasury notes, according to Thomson Financial. The high returns have come despite steep fees, typically 2% of assets per year plus 20% or more of the profits over a predetermined hurdle rate of return, usually the London interbank offered rate (LIBOR). The new funds of funds pitched to the affluent add yet another layer of fees that can run as high as 1.5% a year.
Even if investors can afford to get into a private equity fund, they shouldn't leap at any opportunity. Not all funds of funds are the same, and few private equity investors actually earn the "average" return. That's because the highest returns are clustered in a small group of funds.
MEETING THE TEST
Consider this: The top 25% of private equity funds outperformed the median fund return by more than 10 percentage points a year over the past decade. That means most funds failed to beat even the stock market. "If you're not in the top quartile, you might as well not be in the asset class—you'd be better off in the S&P 500," says Christopher Cordaro, chief investment officer at financial advisory firm RegentAtlantic Capital.
Advisors and brokerage firms create their own funds and, typically, offer them during a limited subscription period. Some also market to other managers' funds. The lowest-minimum funds are usually open only to investors who meet the "qualified client" test as defined in the federal Investment Advisers Act, says Scott Barrington, director of private equity at Piper Jaffray (PJC ). That means a person or couple must have a net worth of at least $1.5 million. Investors also must meet the Securities & Exchange Commission's criterion for "accredited investors": $1 million in investable assets, excluding personal real estate, or an income of $200,000 a year. The SEC in December proposed raising that bar to $2.5 million.
Even if you can qualify for a private equity investment, is this the best time to make it? There's a serious question of whether we're at the peak of a market cycle. Interest rates on junk bonds needed to complete the buyouts remain at rock-bottom levels, while the stock market continues to welcome initial public offerings of the LBOs when the private owners decide to cash in. Those conditions can't last forever.
Indeed, buyout funds started in the late 1980s and mid-1990s earned average returns closer to 10%. As competition for deals increased, firms paid higher and higher prices, leaving winning bidders saddled with huge interest costs that led to bankruptcies. And in periods when junk-bond financing dried up, private equity firms had to sit on the sidelines for years at a time.
The cycle is likely to repeat, so an investor considering a fund of funds should be wary of those that place all their money in offerings opened the same year. "We're more cautious and more selective than last year," says David Bailin, head of alternative investments at U.S. Trust. "If you're not careful, you'll subject yourself to a lot of risk over the next 10 years."
Another tactic is to shun big, broadly based buyout funds in favor of those zeroing in on an industry. One popular trend in 2006 was alternative energy, though the recent drop in oil prices has dampened interest. Other recent funds focused on infrastructure, health care for aging baby boomers, and supermarkets in developing nations.
For those who don't qualify for even the lower-minimum funds of funds or choose not to plunk so much down, there are more accessible private equity plays. Funds run by Kohlberg Kravis Roberts and Apollo Management started trading on Amsterdam's Euronext exchange last year and can be bought by U.S. investors through brokers that offer overseas trading. KKR Private Equity Investors trades at 22.95, down from 25 at its May initial public offering. Apollo's AP Alternative Assets fund is at 19.25, down from 20 at its July 31 IPO.
To get in on the private equity boom, PowerShares Capital Management created an ETF that tracks 30 public stocks involved in private equity both directly and indirectly. Some holdings, such as CIT Group (CIT ), mainly offer financing to private companies while others like Affiliated Managers Group (AMG ) and UTEK (UTK ) specialize in making small and medium-size deals. What little trading history exists suggests that the PowerShares fund closely tracks the return of small-cap financial stocks. For investors who want private equity investments, there's no substitute for the real thing.
By Aaron Pressman