Get a walkthrough of the different ways to invest in private equity and trade commitments and limited partnership units.
Jan 16, 2024
In our first private equity article, we kept things simple by not mentioning the various ways to invest in this asset class.
Actually, it's typically the private equity firm that reaches out to the investors and not the other way around. When the firm wants to establish a new fund, it needs to raise capital for it. They begin reaching out to potential investors, presenting their fund, and inviting investors to commit a certain amount to the fund.
You can read more about commitment, unfunded commitment and the funds' life cycle in the article I linked to above. I would actually recommend that you read that one now to get a foundational understanding of private equity before reading on.
*5 minutes pass while you read the first article*
Welcome back, and now, let's get to it. One walkthrough of the different ways to invest in private equity and trade commitments coming up!
Typically, there's no exit from a private equity investment once you've made your commitment. But over time, it's become possible to trade your commitment and limited partnership units (LPUs) in private equity funds. This market is called the private equity secondary market.
Every private equity firm has their own set of terms in the Limited Partnership Agreement you enter with them. These terms state your options for transferring your commitment and your limited partnership units.
Some firms allow you to sell your unfunded commitment to another investor, who then takes over this commitment. This could be a private investor, a family office, a pension fund, or a so-called Secondary, which is a private equity fund that buys commitments from other private equity investors.
In less common cases, you can transfer to another investor both your unfunded commitment as well as the limited partnership units you've already obtained by contributing capital to the fund.
Note: If you want to specify your options for reselling your commitment and your limited partnership units, you can do this in a side letter (read more about side letters here).
"Over time, it's become possible to trade commitments and limited partnership units in private equity funds. This market is called the private equity secondary market."
The larger and more reputable the fund, the greater the chance of selling your LPUs and your commitment. But beware! The trade has to be attractive for the buyer. This means you should be prepared for a so-called haircut, when selling your commitment and your LPUs. A haircut is an expression used for selling your interests for less than they're worth. Usually it's around 80% of the fund's assessed value.
And it's not even a guarantee that you can find an investor who's interested in buying. The private equity market is significantly less liquid than the public market, and it's much more challenging to find a buyer in the private market. However, the private equity secondary market is growing, offering still more opportunities to buy and sell commitments.
Even so, you should only invest in a private equity fund if you're committed to its entire lifespan as it would still be a risk depending on being able to sell your commitment to someone else later on. And even if you do sell it, you may very well lose money on it.
But if I can sell my commitment, doesn't that mean I can buy someone else's, too?
Yes it does! Just as you can resell your commitment in some cases, you can, in principle, also buy other investors' commitments and LPUs.
You can even make a good deal (remember the haircut) if you have the opportunity to buy someone else's commitment when the fund has started showing results but before the returns really take off, or when the investor is under pressure. Some investors made significant profits by buying distressed investors' commitments during the financial crisis.
A public investment in the private market. A public private investment.
That's some oxymoron. Nonetheless, this is actually possible.
A relatively new method of trading private equity has emerged that allows investors to buy shares in a publicly traded private equity fund or a private equity fund of funds.
This trading option allows smaller investors to participate in the private market, but the selection of publicly traded private equity is still limited.
And there's even another way of investing in private equity through the publicly traded market. Namely, investing in a private equity ETF that tracks a private equity index.
More and more banks offer the opportunity to invest in private equity through them. The way it works is that the bank becomes a Limited Partner in a fund, and then they sell portions of their commitment in the fund to their clients.
You should be aware that this way of trading private equity may involve an extra layer of costs, as the bank also charges for its services related to the investment.
A form of private equity investment that's gaining popularity is co-investments. In a co-investment you have the opportunity to engage in an investment together with a private equity fund – whether you're a Limited Partner in that fund or not.
If a private equity fund in which you've invested offers you the chance to become a co-investor in one of its portfolio companies, you'll not only invest indirectly in the company through your investment in the fund but also directly in the company or through a so-called dedicated co-investment vehicle created for co-investments.
Co-investments can be advantageous for the private equity firm (the General Partner) behind the private equity fund. Let's say they identify an attractive investment opportunity but they don't have enough capital to invest alone or they are prevented from doing it for diversification reasons. If some of the fund's Limited Partners agree to participate in the investment as co-investors, they can go ahead and invest in that particular company. This way, they also avoid the risk of another competing private equity fund entering into the investment agreement instead of themselves.
For you as an investor, a co-investment can be beneficial in that you pay reduced fees or often no fees at all in connection with your co-investment and receive a larger share in a potentially attractive investment than you would through your investment in the private equity fund alone.
However, co-investment is a complex field, and you should always conduct your own due diligence before agreeing to participate in a co-investment. The ability to assess which co-investment opportunities you should engage in is essential.
Last but not least, you also have the option of researching and contacting a private equity fund that aligns well with your investment strategy, situation, and preferences.
If you choose to invest in multiple private equity funds, it's crucial to maintain an accurate and complete overview of all your investments. It's essential that you know your total unfunded commitment at all times and that you're able to compare the performance of the different funds.
Maintaining this overview can be a highly time-consuming task due to the absence of a common standard among private equity funds for calculating and reporting the fund's expenses and results. This means that evaluating performance is not as simple as comparing the key figures and return percentages from the different funds.
At Aleta, we have extensive experience in private equity reporting. We leverage this knowledge to provide you with an accurate overview of fund returns and your unfunded commitments. By using the same method to calculate different private equity metrics across all funds, we enable you to compare fund results.
This way, you're better equipped to make informed decisions for your private equity investments.
Feel free to reach out if you have any questions about the article or our private equity reporting.
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