The Risk of Investing into Private Equity Funds

Investment risks in private equity funds

Private equity funds are complex investment vehicles that are intended to be held for the long term. However, as with every type of investment, there are some risks involved. By being aware of these risks, you can take steps to mitigate them and improve your chances of a successful investment. Investment risks in private equity funds include:

Liquidity risk of PE funds

When investors buy into a PE fund, they are investing in the fund itself, not the underlying portfolio companies. These investors, therefore, have no legal right to any specific assets within the fund, and the fund does not have to sell any specific assets to repay them. If the fund is unable to repay out of its cash flow, the fund’s investors may not get their money back. Liquidity risk is therefore one of the biggest risks associated with PE funds. Liquidity risk has two components. First, a PE fund may not be able to sell a specific asset it has invested in. For example, if a PE fund invests in a company that subsequently goes bankrupt, it may not be able to sell that company’s assets and therefore may not be able to repay its investors. There is also a second liquidity risk for fund investors. Even if the fund sells all of its assets, it may take some time to do so. Investors, therefore, have to be prepared to wait.

Earn-out risk

PE funds often invest in companies that need to make an earn-out payment to repay their debt. These earn-outs are contingent on the company achieving a certain profit level. If the company fails to achieve this profit level, the PE fund may make up the difference out of its pocket. This is called an earn-out risk or earn-out risk for PE investors. For example, a PE fund may invest in a company and agree to repay the debt it owes its creditors with interest over five years. If the company later fails to achieve the profit level it needs to make these repayments, the PE fund must make up the difference out of its pocket.

Leveraged Buy-out (LBO) risk

PE funds often buy companies that are heavily in debt and then refinance that debt with debt they raise from investors. These are mainly debt-to-equity funds (also known as LBO funds). Investors in these funds, therefore, face two potential risks. If the company fails to make the repayments on the debt, the creditors may foreclose on the assets and sell them. If the assets are not sufficient to repay the debt, the equity investors may lose some or all of their investments. If the assets are sufficient to repay the debt, the debt holders may decide to foreclose on the assets and sell them to repay the debt. If the assets are insufficient to repay the debt, the equity investors may lose some or all of their investments.

Market risk

PE funds invest in specific companies and sectors. If those sectors do well, the funds will do well. However, the overall market and economy can also affect the performance of PE funds. For example, if a fund invests in a specific industry that is heavily dependent on external factors (e.g. the oil or gas industry), the overall market may affect that fund’s performance. If the economy is doing poorly and demand for the industry’s products is low, the company may not do well and the fund may lose money.

Human Capital Risk (HCM)

PE funds hire employees to help them make successful investments. If those employees fail to perform, the fund’s performance may be negatively affected. Human Capital Risk refers to the risk that these employees may not perform well and negatively affect the fund’s performance. Several factors can lead to Human Capital Risk for a PE fund. If a PE fund hires employees with proven track records, it may be hiring seasoned veterans who have worked in several industries and have a lot of industry experience. Alternatively, the PE fund may hire employees straight out of school or with very little industry experience. Human Capital Risk also occurs if the PE fund hires managers who fail to perform. For example, if the PE fund hires someone who has a proven track record as an investment manager, but they fail to perform, it may negatively affect the fund’s performance.

Other risks

- Business risk: If the PE fund invests in a company that fails, it may not be able to repay the investors. - Credit risk: If the company the PE fund invests in is unable to repay the debt, the fund may lose part of its investment.

- Liquidity risk: If the PE fund cannot sell its assets, it may not be able to repay the investors.

- Currency risk: If the fund invests in a company outside of its home country, and the value of that currency goes up, the fund may lose money.

Conclusion

As with any type of investment, the best way to mitigate investment risks is to do your research and understand the risks. If you are considering investing in a PE fund, it is important to understand that fund’s risk profile and its strategy.