So you think you want to invest in a private equity fund

Disclaimer: this post is specific to buyout funds — private equity funds that buy existing businesses, including public companies and divisions of existing companies, usually with leverage — and not venture capital funds.

Introduction for the uninitiated: A private equity/buyout fund raises hundreds of millions or billions of dollars from institutional and individual investors (collectively called “Limited Partners”), to be invested by a team of investment professionals (collectively called “General Partners”), in the form of ownership stakes in existing operating businesses — typically public companies and divisions of existing companies. Private equity funds typically use a large amount of debt in order to buy much larger companies than they could normally afford. Returns are realized only one way: by subsequently selling those same businesses — either to the public via an IPO, or to another company via a sale. The General Partners typically take 20-30% of the investment profit plus 2-3% management fees annually, plus often additional fees, perhaps levied against their companies. After those fees, the Limited Partners still expect to generate returns well in excess of the S&P 500 index, even though their money is locked up for as long as 10 years in the process. Lately, the amount of money flowing into private equity firms has been exploding, and certain large private equity firms have announced or are considering going public themselves.

15 questions to ask when you are thinking of investing in a private equity fund:

Your fund will use a significant amount of debt when purchasing operating businesses. Interest rates are currently quite low — in fact, not that far off of 40 year lows, making that debt quite cheap. What happens to your model and projected investment returns if interest rates rise?

The interest rate spread between Treasury bonds and so-called “high yield” bonds is currently near all time lows. The debt that you will be using will fall into the category of “high yield”. What happens to your model and projected investment returns if this spread widens?

Price/earnings multiples in the public markets for large and mid cap companies are low relative to 20-year historical norms, making them relatively cheap to buy.What happens to your model and projected investment returns if public P/E multiples expand — from, say, the current ~16 to not unreasonable levels like 20 or 24?

What part of the excess return over the S&P 500 index that you are expecting to generate is due to your use of leverage (debt)? Does this indicate that the public companies that you plan to buy are underleveraged? The finance theory of leverage is that a company should take on debt until its cost of that debt is greater than the returns it can generate from that debt — what happens to your model and projected investment returns if public company shareholders and CEOs figure this out and add more debt before you are able to buy them? Further, if what you are really doing is leverage arbitrage versus the S&P 500, why can’t I just buy an S&P 500 index position myself and leverage it up by purchasing call options and get the same result for a fraction of the fees?

What part of the excess return over the S&P 500 index that you are expecting to generate is due to your assumption of higher levels of risk and volatility than the index? What are your internal estimates of the true risk and volatility of your investment portfolios? Will you share those internal estimates with me? If not, why not? And again, why can’t I replicate a riskier S&P 500 index myself via index funds and call options for a fraction of the fees?

What part of the excess return over the S&P 500 index that you are expecting to generate is due to the fact that you are buying so-called “value” companies and avoiding so-called “growth” companies, thereby taking advantage of the theoretical return premium many finance professionals believe is associated with value companies? Why can’t I replicate that effect myself simply by buying a value index for a fraction of the fees?

What part of the return premium that you are expecting to generate is due to the fact that you plan to lock up my money for up to 10 years, thereby extending my investment horizon to 10 years and removing from me the ordinary temptation to sell in a panic when stocks drop? Why can’t I replicate that illiquidity premium by simply buying the index, or a leveraged/riskier version of the index, and not selling myself for 10 years? And if there is no illiquidity premium, why am I agreeing to have my money locked up for 10 years?

What part of the return premium that you are expecting to generate is due to the operational improvements that you are implementing in the businesses that you buy? When one of your management consultants or operating partners walks into the tire company you just bought, wearing his $3,000 Zegna suit, $400 Turnbull & Asser shirt, $80 Pantherella cashmere socks, $900 A Testoni alligator loafers, $5,000 Omega watch, $500 Gucci cufflinks, and $150 Hermes tie, what exactly is he telling the general manager of that tire company about running that business that the general manager didn’t already know?

You cite high returns generated by your previous funds. Do you still have the same investment team as your previous funds? Are they still as motivated notwithstanding the fact that their net worth is probably at least several hundred million dollars apiece?

Are you still investing in the same sectors as your previous funds?

Are you still buying the same size companies as your previous funds?

There is a much larger amount of capital at work in the private equity world today than there was when you raised and ran your previous funds, and therefore significantly more competition for each deal. What impact do you think this huge influx of money and corresponding greater competition will have on your ability to generate comparable investment returns with your new fund?

Your industry is gearing up mightily to fight the proposed reclassification of so-called “carried interest” — the 20-30% of investment profits that your General Partners get to keep — as ordinary income rather than capital gains. The underlying logic of this fight has to be that your General Partners would not be as motivated if they were getting taxed at ordinary income rates, versus their current taxation at capital gains rates. If this proposed reclassification passes Congress and the President signs it into law, are your General Partners going to pick up their marbles and go home in protest?

Given that most of the returns in private equity historically flow to the top 10% — or even top 10 — firms, what basis do you have for believing that your fund will be in that top 10% — or top 10?

Finally, given the extraordinarily high level of demand from really smart institutional and individual investors to invest in high-quality — top 10% or top 10 — private equity funds, why exactly am I being given the opportunity to invest in yours?