Private equity (PE) is a great option to diversify your investment portfolio, especially for individuals with high net worth and institutional investors. One of the main reasons for investing in private equity is to improve the risk and reward characteristics of an investment portfolio. Private equities provide investors the opportunity to generate high returns.
Many might be feeling pessimistic about private equities in light of the global pandemic, but a 2021 study from Deloitte South Africa shows that private equity activities are expected to increase.
Most respondents, who are owners of PE firms or investors, expect a rise in PE investments specifically across East, North, Southern and West Africa, based on the expected recovery from the economic impact caused by the pandemic.
While private equity can potentially provide high returns, it also comes with risks. Portfolio diversification, whether in private or public markets, should be considered carefully and with the advice of financial professionals. In this article, we’ll discuss the five key risks investors will face with private equities and how to manage them.
What is private equity?
In simple terms, private equity is an alternative form of private financing. It does not procure its funds from public markets but from investors directly investing in companies. PE investors are generally either wealthy individuals or institutional investors, which are PE firms investing money on behalf of their clients. These companies include pensions, financial services, mutual funds and insurance companies.
Private equity firms are organisations that aim to improve the companies they invest in by either replacing or – as in IFSA’s case – being part of the management team and board of directors. These firms also sometimes engage in the operational aspect which includes cost-cutting, modifying products and services, or selling part of the company in a bid to raise funds. All of these actions meant to increase the return on investment for PE investors.
You can find PE firms involved in various industries, including technology, healthcare and biotechnology.
5 private equity risks investors face
There are five types of private equity risks that investors typically deal with.
1. Operational risk
Operational risk refers to the risk of loss resulting from inadequate processes and systems that support the organisation. This may include IT systems that don’t function correctly, insufficient manpower, or systems that are outdated.
The company’s operations should be one of the key elements to consider before investing.
2. Funding risk
Funding risk happens when investors are not able to provide funds for the investments. This is when the investor will be considered an “investor default risk”. Generally, private equity funds do not require the full capital until the investments have been identified. Funding risk can also be related to liquidity risk. When investors are faced with inadequate funding, they might be required to sell illiquid assets to meet their financial commitments.
3. Liquidity risk
Liquidity risk can occur when a company that is borrowing money is unable to pay it back. This may be due to financial difficulties or when the company has used up its capital. In PE funds, investors are committed to the investment for a long period – usually between five to 10 years, during which time they’re not able to redeem or liquidate their investments.
4. Market risk
There are different forms of market risks that can affect your PE investments. These include foreign exchange and commodity prices, fluctuating interest rates, geographical location and market exposure. Unlike public markets, public equity investments are reliant on isolated valuations that typically occur quarterly.
5. Capital risk
Capital risk refers to the possibility of losing the investor’s capital over the investment’s lifetime. This form or risk can be closely related to market risk in that the uncertainties of unrealised gains or losses will affect the realised gains or losses at the end of the investment’s lifetime.
This can happen if the chosen investment has underlying issues and suppressed equity prices. It can also be affected by the fund manager’s ability to select a portfolio of companies. This is why it’s important to select a credible fund manager who is able to select companies with good growth prospects that can create value at the end of the fund’s life.
How can you manage private equity risks?
While you can’t avoid these risks entirely, you can manage them effectively to minimise your exposure. One way you can do this is to ask important questions that can help you make a more informed decision. Some of these questions include:
Will adding private equity add value to your portfolio?
As private equity investments are considered concentrated, a typical PE fund will have 10 to 20 companies per fund. This means there’s an increased risk with each company. Can your portfolio handle the concentration, and will this add value or devalue your investment?
Will fees reduce the overall returns?
PE fees are usually higher than other investments. Will your overall returns be higher the fees accumulated throughout the process?
What is the investment history?
Look into the history of the PE investments you’re considering. Have they provided high returns over the last few years? Is there an upwards pattern to their growth? PE investments with lower investment requirements typically do not have long histories.
How will these private equity risks relate to certain industries, and are they worth it?
Different sectors will carry their own set of risks. It’s important to understand how these risks will fare in certain industries and whether it’s worth investing into them. For example, if you’re eyeing the technology industry, you’ll have to examine the operational risks more closely.
Additionally, when evaluating a private equity firm, it’s important to do your due diligence and check on these items:
- Information of the firm and its partners
- Investment strategy
- Deal flow
- Company-level due diligence capabilities
- Performance track record
How IFSA’s strategy minimises these risks
At IFSA, we understand that investors want to feel secure and informed. We focus on family-owned and SMME businesses and make it our mission to create value for our clients. Our team has the experience and knowledge to select a portfolio of companies with good growth potential and solve any challenges our clients might face along the way.
We understand that each investor will have a different experience and needs to be comfortable with their fund manager.
We are all about building real and personal relationships. Members of our organisation are also members of the board of directors of the firms we invest in, which makes us confident that we can help diversify your portfolio according to your risk appetite.
Don’t let private equity risks stop you from diversifying your portfolio. Get in touch with us and let us walk you through how our approach helps to minimise risks.
IFSA (Pty) Ltd Registration No. 2000/005153/07 An Authorised Financial Services Provider Licence No. 43337