Three Considerations for Your Private Equity Structure

This is the third blog in a private equity series based on our guide, “Succeed in Private Equity Investing”.  You can see the previous blog here.

Having determined the size of your private capital allocation, you will then want to determine the implementation structure of the portfolio. Private capital investing can take the form of direct investment in private companies, investment in funds organized by private capital managers or investment in a commingled portfolio—fund of multiple private capital managers (such as a fund of funds or a separate account). There are pros and cons to each approach.

Investors need to consider both internal and external factors in deciding how to structure a private capital portfolio. While larger investors, with greater staff capabilities, experience and resources, may be able to identify and manage direct investments, most investors choose to become limited partners in private capital funds— either directly or via a fund of funds or customized account. Finding a structure that matches your organization’s skills, resources and risk tolerance is important.

Here are the three alternatives to consider:


Direct Investment
In direct investment, no investment manager is involved. Instead, the investor commits capital directly to a privately held company or asset, becoming a full or part owner. Some large institutions invest directly into private equity-backed companies, typically as a co-investor alongside one of their own investment managers, but sometimes as a stand-alone majority or minority investor.

The primary advantage to direct investment is the absence of investment management fees. As a counterweight, however, the investor must bear all the costs of sourcing and evaluating the investment, and of building and managing the portfolio. This includes retaining specialized staff to identify, analyze, manage and dispose of the investments on a timely basis at favorable prices. Each of these steps is time-intensive. Often is it challenging for these investors to gain access to meaningful “deal flow,” the term private capital managers use to describe the stream of investment and disposition opportunities from which they choose.

Direct investment can be a risky approach because portfolios are often concentrated; and, achieving meaningful diversification requires considerable capital and management resources. For these reasons, few institutions are able to follow a direct investment strategy.


Investment through Direct Relationships with Private Capital Managers
In this structure, investors, as limited partners, commit capital to a fund or limited partnership organized by a private equity or venture capital manager who typically acts as the general partner. As described earlier, the life of the fund is usually 10 to 12 years. Over extended periods of time, a manager generally operates a series of such funds.

The biggest drawback to direct manager relationships is that there are so many managers—well over 7,000 in the global venture capital and private equity sectors alone— that it is difficult for some institutions to identify and obtain access to those with the “hands-on” skills needed to drive their portfolio companies to success. Access to these top-tier managers can be more problematic for small and mid-sized investors and for those who are new to private capital, since, as a practical matter, most established managers are selective, preferring to work with relatively few limited partners able to commit substantial long-term capital. Furthermore, it is not unusual for top-tier managers to have high minimum investment thresholds, meaning that it can take years of relationship building for a smaller investor to obtain access to a desired manager. Another challenge for some modest-sized plans is gaining access to multiple managers to achieve adequate diversification by manager, stage and geography.

In summary, this approach allows investors to build relationships with private capital firms and pay fees only to those managers. While not as resource-intensive as direct investment, this structure still requires extensive time and expertise for manager due diligence, risk management, legal review, manager monitoring, administration, reporting and management of in-kind distributions. If an institution is appropriately staffed, and has direct and meaningful access to a diversified group of top-tier private capital managers, this is a good approach. As responsible stewards of an institution’s portfolio, however, comparison of in-house efforts, current or planned, should be weighed against other viable alternatives, including outsourcing, engaging an expert or specialist consulting firm, or using a credible fund of funds or customized separate account managers as partners.


Investment in a Commingled Portfolio or Customized Account of Multiple Managers— the “Fund of Funds” or “Manager of Managers” Approach
This is the structure most often used by Commonfund Capital. A manager raises a fund— sometimes called a “fund of funds”— or manages a customized account to invest in partnerships run by several different private capital investment managers. Some investors find one or two fund of funds or customized account managers sufficient for their portfolio; others use this strategy as the core of their private capital program and selectively invest with additional managers on a direct basis around that core.

This approach offers several advantages. Access to top-tier managers—the key driver of performance—is the most important advantage. In addition, investors achieve diversification, both across the portfolio and within a particular investment strategy via a single investment.  Risk in a fund of funds or customized account is spread among multiple managers and across 200 to 800 (or more) underlying investments, compared with only a few investments in the direct approach or 10 to 40 underlying company investments with a single manager.

One drawback to the fund of funds or customized account approach is that the investor pays a fee to the manager of managers. Fees can vary dramatically, however, so investors should carefully compare manager of managers’ fee structures. Another characteristic of this strategy is that reporting can be slower than investing directly with a single manager because results must first be obtained from the underlying managers before being aggregated by the fund of funds manager.


Interested in learning more about these important considerations when building  a private equity portfolio? Download our guide -Succeed in Private Equity  Investing.




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