What to look for when investing in private equity

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High-net-worth investors and family office typically have a portion of holdings in private equity in both bull and bear markets, and even in high-interest fixed-income environments. While this type of asset offers a variety of advantages, there are also issues to look out for.

Private equity can offer opportunities not necessarily available to retail investors. “An overwhelming 90 per cent of North American family offices have a stake in private equity,” according to RBC and Campden Wealth’s 2023 North America Family Office Report.

“Of this investment, 42 per cent is achieved through direct participation, and 49 per cent through holdings of funds or fund[s] of [a group of] funds,” the report says.

“The stability of private equity is one reason that it has become popular with high-net-worth investors,” says Pierson Chan, wealth advisor and portfolio manager with Nicola Wealth in Vancouver.

“Private equity can be less fickle than public markets, which are more sensitive to short-term news headlines. With private equity, an investor typically has to commit to a longer period [or pay a penalty]. You lock up their capital, in many cases for years. In exchange, the investor usually gets lower volatility,” Chan says.

What questions to ask when investing in private equity

Another advantage of private equity is that the due diligence is rigorous, says Kazuki Nohdomi, Nicola Wealth’s private equity and venture capital fund portfolio manager in Vancouver.

“We look closely at the private equity investment’s management team, their strategy and the overall investment environment. We go deep,” he says.

“We want to know the management team’s track record; we want to know what kinds of companies they’re investing in using the funds they raise, and where these are located,” Nahomi says.

“Ideally, the key decision makers in a private equity firm have been through a few business cycles, so they know how to deal with ups and downs. It’s also important for a private equity team to have some diversity in their decision making,” he says, because the economy and business climate are always changing.

“You don’t want a team where everyone thinks the same way all the time,” he says.

Arthur Salzer, founder and chief executive officer of Northland Wealth Management in Oakville, Ont., agrees that it’s important to know as much as possible about the inner workings of the private equity investment.

“With private equity, you’re expected to trade on material inside information. Otherwise you wouldn’t do the deal,” Salzer says.

“You can take what you know about what goes on inside the company and do a better deal [than what could be achieved in a public market investment],” he says.

Examples of due diligence

It’s important as part of due diligence to look at the sectors, types of business and the locations that private equity companies and funds invest in, Nohdomi adds.

“For example, we invested in a company that provides HVAC (heating, ventilation and air conditioning) services. It operates in the U.S. Southeast. We looked closely at prospects for that kind of business in that region,” he explains. The region is prone to the ravages of climate change, experiencing tropical storms, extreme heat and cold snaps.

Looking at the overall investment environment means analyzing whether private equity investments that are particularly popular at a given moment might be overpriced, Nohdomi says.

“When there’s a lot of money chasing private equity and the prices are high, we want to understand how that type of business is going to grow,” Nohdomi says.

“We look at what a company’s protection is from the downside of [an economic] cycle. We look at their cash flow and their ability to grow their cash flow, whether they can resist downturns in cycles,” Chan says.

Are higher fees for private equity investments worth it?

The fees for private equity investment can be a challenge for some investors, Chan says.

“Fees can be higher than for a public investment, such as an ETF [exchange traded fund], because the due diligence threshold for private equity is so much more detailed,” he says.

“The typical fee structure for private equity is known as ‘2 and 20’. It’s a 2-per-cent [annual] management fee for the fund, regardless of how it performs, and then 20 per cent of the profits as an additional fee to the investment manager. It’s not the only fee structure for private equity but it’s common,” Chan says.

Some private equity investments allow managers the discretion to “co-invest” in other promising private direct deals related to the main investment. “In such situations there usually is no management or performance fee for this part of the deal,” Chan says.

Such co-investments can be lucrative if they involve a sector that’s growing fast, but they also can put investors at risk by concentrating too much on one company or one type of business, he adds.

“You have to make sure you look at the entire portfolio to make sure you’re not overconcentrating,” he says. In fact, given the ability of private companies to move quickly and nimbly into new lines of business, “the opportunities for diversification can be huge,” Chan adds.

What sectors are getting attention in private equity investing?

“The universe of private companies is much larger than that of companies in the public markets.”

Private equity gives family offices the opportunity to invest in leading-edge and emerging technologies, and many family offices are seizing the opportunity, RBC’s report notes.

“Notably, artificial intelligence has garnered substantial attention, with a net 31 per cent of family offices seeking to increase their [investment], and 14 per cent intending to initiate exposure … Healthcare and digital transformation are also popular technology sectors,” the RBC report says.

Not every type of private equity play is popular, though, RBC’s report adds. “There is very limited enthusiasm for consumer internet and the Metaverse.”

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