Recently, a popular private equity firm made headlines, but not for all the right reasons. My first experience with this company was when I inherited an elderly client who had two-thirds of her retirement portfolio invested in their funds. She had no idea what she was invested in or the significant risks associated with the investment.
To make matters worse, the broker who sold her the investment earned a 4% upfront commission on her portfolio. On her R20 million investment, he pocketed an astonishing R800 000. I couldn’t help but feel this person had failed to act in her best interest.
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When I reviewed her portfolio, it became clear that it didn’t align with her risk tolerance or financial needs. I recommended moving her portfolio into a lower-risk, highly regulated investment that better suited her goals and overall asset allocation strategy. However, both she and I were shocked to discover there was an 18% penalty for withdrawing her funds within the first two years.
On further investigation, I found that while she was sold the fund as a “low-risk investment”, the private equity fund was actually investing in early-stage startups – a category that is anything but low risk. This experience underscores the importance of understanding what private equity really entails and whether it’s suitable for your financial plan.
What is private equity?
Private equity (PE) involves investing in privately held companies, often through funds managed by private equity firms. These investments are typically illiquid, long-term, and aimed at generating significant returns by actively improving the performance of the companies within the fund’s portfolio.
Key features of private equity:
- Long-term lock-in: Investments are often locked up for five to 10 years or more.
- Active management: PE firms play a hands-on role in driving growth and increasing value in the businesses they invest in.
- High risk: Many funds include investments in startups or companies undergoing restructuring.
While private equity can be lucrative, it is not without risks, and it’s crucial to understand its complexities before committing.
The risks of private equity investments
1. Illiquidity
Private equity investments are highly illiquid, meaning you can’t access your money for years. Even when withdrawal is possible, as my client discovered, it often comes with hefty penalties.
2. High fees
Private equity fees can be exorbitant, including:
- Upfront commissions: Often as high as 4% to 5%, incentivising brokers to sell these products regardless of their suitability.
- Management fees: Typically 1% to 3% of committed capital annually.
- Performance fees: Often 20% of profits above a certain threshold.
These fees can significantly erode returns, especially for smaller investors.
3. Misalignment with risk profiles
As seen in my client’s case, private equity funds are sometimes sold as low-risk investments when they involve high-risk ventures, such as early-stage startups or distressed companies. This misrepresentation can be disastrous for conservative investors.
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4. Lack of transparency
Private equity funds often provide limited information about their underlying investments. Investors may not fully understand where their money is going or how it’s performing.
Who should consider private equity?
Private equity investments are not for everyone. They are best suited for:
- High-net-worth individuals: Those with substantial capital who can afford the risk and illiquidity.
- Sophisticated investors: People who understand the complexities of private equity and have access to professional advice.
- Long-term investors: Those who can commit funds for extended periods without needing liquidity.
What to look out for
If you’re considering private equity, here are some red flags to watch for:
- High commissions: Ask how much the advisor or broker earns on the product they’re recommending.
- Withdrawal penalties: Understand the terms of the investment and the costs of exiting early.
- Vague descriptions: Insist on clarity about the fund’s underlying investments and risk levels.
- No regulation: Ensure the fund is regulated by your country’s financial authorities, such as the FSCA in South Africa.
Final thoughts
Private equity can offer high returns and unique opportunities, but as my client’s experience shows, it’s not suitable for everyone. The risks, high fees, and lack of transparency make it critical to approach these investments with caution.
Always ensure that your investments align with your risk tolerance and financial goals, and work with an advisor who prioritises your best interests.
If you’re considering private equity or need help navigating your investment options, let’s chat. Together, we can craft a strategy that aligns with your needs while minimising unnecessary risks.
