The Hindu Business Line : Beyond traditional investments: How about pvt-equity mutual fund?

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Beyond traditional investments: How about pvt-equity mutual fund?

B. Venkatesh

Equity values have declined considerably since January 2008 and are unlikely to move up at the same speed as in the previous years. Bond prices are also down as the market is aligning itself to higher inflation.

The commodity markets, according to some, carry high risks. This has forced institutional investors and HNIs to venture into alternative markets.

Private equity investments, for instance, has increased considerably in recent times. Small investors do not enjoy such alternatives.

This article, hence, explores the possibility of providing small investors an exposure to the private equity market.

It suggests a fund-of-funds structure so as to reduce the high risk associated with such investments. Importantly, a private-equity mutual fund will have to look beyond the traditional open-end or closed-end style so as to align itself with the illiquid nature of the investment.

Private Equity Fund

Private equity funds are typically limited partnerships. The firm has general partners and limited partners. The general partners have management control and are typically the founder-members of the firm.

The limited partners merely provide investment capital. The liability of the limited partners is restricted to the investments in the fund. Such partners are normally institutional investors.

Private equity funds typically have a finite life. They invest in equity of unlisted companies.

High risk and illiquidity provide for higher returns on such investments. A hurdle rate, which is the minimum return that the fund strives to achieve, is fixed with the consent of all partners.

The general partners take a share of profit beyond the hurdle rate and the balance is distributed to the limited partners.

Private equity funds play an active role in monitoring and advising the companies in which they invest because they acquire a large stake in such entities.

The question is: Can this structure be available for small investors?

Mutual fund, a limited partner

Asset management firms can float private-equity mutual funds. Such a fund need not directly invest in private equity. Rather, the fund manager will identify private equity funds that will invest in unlisted companies.

The general partners of the private equity fund will perform due diligence on the investments. The mutual fund will be a limited partner, eligible for a share of profits in the private equity fund.

In essence, the private-equity mutual fund will operate as a fund-of-funds. The mutual fund manager will involve in manager selection picking high-quality private-equity funds to optimise returns.

Such a structure will provide small investors exposure to several private equity funds, which would not be possible if the private-equity mutual fund were to directly invest in companies. Besides, such a structure reduces risk of failed investments.

Given the illiquid nature of such investments, it may not be optimal to adopt a closed-end or open-end structure for the mutual fund.

The mutual fund should not provide an exit route to the small investors till the longest maturity private equity fund in its portfolio folds. Suppose a mutual fund has investments in three private equity funds where the exit routes on individual investments range from three years to seven years, the fund’s life will be seven years.

Exotic betas, associated risks

Private equity funds typically take exposure in unlisted companies in high-growth areas such as biotechnology, Internet commerce and telecommunications. This imposes two kinds of risk on the investor-business risk and illiquidity risk.

It is this high risk that provides opportunities for higher returns. Such investments are termed exotic beta exposure, because they generate higher returns than normal beta investments would.

Typically, companies that issue private equity promise their investors net fixed return with an exit route. One exit route can be share buybacks by the promoters. Another route could be the IPO window.

The private-equity mutual fund investors face two other risks. These are sorting and incentive problems. A sorting problem arises due to asymmetric information.

The promoters of companies that issue private equity know more about their company than do private equity investors. This leads to the problem of adverse selection.

The second problem is that of incentives. The general partners may sometimes make investments that are more aligned to their interests than to the overall interest of the private equity fund.

The sorting problem exists even if the mutual fund were to invest directly in private equity.

The incentive problem can be minimised by providing a performance-based compensation structure to the general partners.

Conclusion

There is a need for small investors to explore alternative investments because of the substantial decline in risk-adjusted returns in the traditional markets.

This article argues that small investors should be provided access to private equity through the mutual fund route. Suitable changes have to be made in the fund structure to accommodate the illiquid nature of private equity investments.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)

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