The risks associated with investing in private equity

The private equity market has grown substantially in the past 25 years. In 1980, investors committed $5 billion to this investment class. In 2007, according to the National Venture Capital Association, 248 venture capital firms raised a total of $35.9 billion of new funding for private equity. What accounts for this dramatic growth?

THREE CATEGORIES OF PRIVATE EQUITY

VC firms typically are partnerships that pool resources to raise capital for a few companies-typically 15 to 20. Larger partnerships might expand to between 25 and 30 firms. In addition to providing capital, VC firms often help businesses develop their management teams, and frequently they take seats on the businesses' boards of directors.

Most businesses begin with the founding entrepreneurs putting up the initial funding. This step is followed by what are called angel investors-generally someone who has a personal relationship with the entrepreneur or possesses industry-related expertise and is willing to take a high degree of risk with a start-up. VC usually is the second or third stage of traditional start-up financing.

LBOs involve acquiring businesses using mostly debt and a small amount of equity, with the debt being secured by the assets of the business. Mezzanine financings are late-stage venture capital investments, usually the final round before going public.

BALANCING RISK AND REWARD

Private equity excites many investors because of the opportunity it provides for spectacular returns. It is reasonable to assume that high-risk, illiquid investments are priced to deliver larger expected returns than publicly traded securities as compensation for accepting greater risk. But returns alone are insufficient reasons for considering this type of investment. Investors should also ask: Are the absolute high returns sufficient to compensate me for the significant incremental risks involved?

According to Venture Economics (a research firm that provides data on the private equity industry), VC (the riskiest of private equity investments) just matched the returns for small-cap value stocks. And because of its greater risk, early-stage VC provided the highest return: 20.2%. Later-stage VC actually underperformed the returns of small-cap public companies, returning 13.8%. LBOs also returned 13.8%, whereas mezzanine financing returned just 9.1%.

Also consider that private equity returns have extreme positive skewness in returns. The median return of private equity is much lower than the mean (arithmetic average) return. Their relatively high average return reflects the small possibility of a truly outstanding return, combined with the much larger probability of a more modest or negative return. Private equity investments are like lottery tickets: they provide a small chance for a huge payout but a much larger chance of a below-average return.

Other factors to consider are that with private equity investments, you forgo the benefits of liquidity, transparency, broad diversification, and the access to daily pricing that publicly traded securities enjoy.

When considering private equity investing, heed the advice of David Swensen, chief investment officer for the Yale University Endowment: "Understanding the difficulty of identifying superior hedge-fund, [VC], and [LBO] investments leads to the conclusion that hurdles for casual investors stand insurmountably high. Even many well-equipped investors fail to clear the hurdles necessary to achieve consistent success in producing market-beating, active management results."

Private equity clearly is a case of caveat emptor-let the buyer beware.

The author is a member of Thomas, Wirig, Doll & Co. Capital Performance Advisors in Walnut Creek, California, and a Medical Economics editorial consultant. The ideas expressed in this column are his alone and do not represent the views of Medical Economics. If you have a comment or a topic you would like to see covered here, please e-mail medec@advanstar.comAlso engage at http://www.twitter.com/MedEconomics and http://www.facebook.com/MedicalEconomics.