Individual investment in private equity: unique risks, but greater potential for higher returns

A trend that’s quietly growing is individuals directly investing in private equity funds.

The traditional model for private equity is to raise capital from pension funds, such as AIMCO, BC Investment Management Corp. (bcIMC) and Ontario Teachers Pension Fund, and invest the money in buyouts of private companies. This occurs increasingly on a larger scale as pension and private equity funds continue to increase their funds under management.

However, individual investment in private equity funds is catching on as more middle market funds have success in raising capital by tapping directly into networks of high-net-worth investors. Investors include entrepreneurs, CEOs and executives with between $100,000 and $2 million to invest in private equity as an asset class within a diversified portfolio.

Tyler Smyrski, vice-president of Yellow Point Equity Partners, said the reason is simple: “Canadian private equity returns have averaged 15.8% in the last 10 years compared with 4.6% for the TSX.”

The higher returns compare favourably against other asset classes such as real estate and bonds. Although private equity returns are down in the last five years, they still compare well against public markets.

Yellow Point is a private equity investment firm that specializes in management buyouts and growth investments for middle-market companies based in Western Canada. The firm is selective in choosing its investors, which include more than 35 CEOs.

“We see a real benefit in having this network, a deal sourcing platform with relationships that can help build our investee companies,” said Smyrski.

Another example is Maxam Capital Corp., which created a $100 million fund in mid-2008 to take advantage of the credit crunch by focusing on structured, opportunistic and undervalued investments. The investors were all high-net-worth individuals, all but one of whom had done business with fund managers and founders Johnny Ciampi and Sean Morrison or their investment committee. Investment sizes ranged from $500,000 to $10 million.

Private equity as an asset class carries some unique risks and might not be for everyone. For example, securities are illiquid because they don’t trade on an open market, and investors are normally locked in for five to eight years and up to 12 years in extreme cases.

Moreover, because the under lying assets are investee companies, they are valued each year through an independent valuation, which can be subjective, and ultimately returns are realized only through selling the companies.

However, the upside can be greater returns, realized through buying at lower valuations, consolidating companies within an industry, facilitating growth or realizing operating efficiencies.

The fund manager (general partner) provides the investors (limited partners) a preferred return before getting any returns itself, plus a share of excess returns above this hurdle rate.

The next potential growth area for private equity is to attract the sophisticated retail investor.

For individuals with a long-term time horizon, seeking higher-than-average returns, private equity can be an asset class worth considering. •