Imagine the possibility of returns that outstrip the stock market. This potential is what draws many to private equity. However, the private market landscape has unique characteristics and risks that are often unfamiliar to investors, especially since private equity used to be only accessible to a select few. These barriers have begun to lower allowing for a much wider audience of investors to tap into its potential. 

So while private equity investing hasn’t traditionally been for everyone, it can be a highly effective vehicle for the right investor, even for those without former experience. To help uncover why, let’s unpack some of private equity’s key risks and downsides.

Private companies - early phase and growth risks

By investing in companies in their early phases, private equity (PE) investors have greater exposure to the risk of company failures.  Investing in startups, for instance,  is riskier than investing in scaleups, as scaleups have at least some track record of success in their market. Scaleups, though, are generally at more risk of bankruptcy than mature businesses, like industry incumbents and well-established enterprises which may be buyout targets.

Most startups fail to reach their goal of providing financial returns to shareholders, a risk that needs to be weighed against a private equity fund’s higher return potential. While adding exposure to higher-risk investments can boost an investor’s potential outperformance, exposure to too much risk can have diminishing returns on a portfolio’s risk/return profile. 

Professional investors generally allocate about 20% of their assets to PE, which is a sizable enough allocation to benefit from the outsized return potential.

To help reduce the risk of capital loss that comes with investing in a single startup or scaleup, investors will often diversify through pooled investments such as PE funds, which typically invest in 10-20 companies, providing diversification.

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PE funds - balancing high risk/return with accessibility challenges

PE funds pool capital and invest in private companies with the aim of achieving above-market returns. They may focus on certain growth stages or industries or be more diversified by company size and industry. Investing in PE typically entails fees higher than public investment options (like mutual funds or exchange-traded funds. PE funds typically consist of management and performance-based fees. These higher cost profiles are easily justified by the often outperforming returns. 

The fees cover the costs of curating an investment pool, performing extensive due diligence and advising a portfolio of companies. While mutual fund managers decide what publicly traded stocks to buy and when to execute trades (often based on algorithmic insights), PE managers are advisors to the underlying businesses.  They work hand-in-hand with a company’s management team to build the business and bring its products to market. The success of a PE fund therefore relies heavily on the skillset and business acumen of the fund manager. 

Unfortunately, direct investment in PE funds is an unrealistic option for most investors. Access to private funds is often limited to personal or professional networks of investors. The funds often require a commitment of US$2 million or more. Adding to this hurdle, an investor generally needs to hold 7 or more private funds to sufficiently mitigate the risk of capital loss (as shown in the chart below). The capital required for a diversified set of direct private fund investments is therefore out of reach for most individuals.

PE fund of funds – delivering accessibility, diversification and value

A fund of funds provides the diversification required to substantially reduce the risk of capital loss. With one transaction, a fund of funds invests in 7-10 underlying funds without requiring an investor to commit the capital required for each separate fund.

At Carbon Equity, our portfolio funds are constructed with a fund of funds structure, providing a curated selection of PE funds based on thorough due diligence and strict investment requirements. In a fund of funds structure, the manager (such as Carbon Equity) provides additional research and hands-on client support. Through our expert selection process, we seek to invest in PE fund managers with impeccable track records of capital stewardship and value creation.  A fund of funds can provide better risk-adjusted returns over time while retaining most of the upside return potential of PE. 

With the added layer of research and curation of a portfolio of funds (which in turn are curating portfolios of private companies, resulting in a total portfolio of up to 150-200 companies), there are additional management fees in a fund of funds. Carbon Equity fees only represent a small portion of the investment costs (on average 14% of the total fees). However, fees should always be considered when choosing an investment. If the investment performs well, an investor will recoup the additional management fees. However poor performance can be exacerbated by the higher expenses of a fund of funds vehicle. 

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Illiquidity risk – the cost of value creation

Most of us are familiar with stock or bond funds that can be redeemed at any time, providing ample liquidity. PE generally does not provide such opportunities for liquidity. When committing to a PE fund, it is for the long term, with a typical investment time horizon of 10 years or more.

So what do investors gain from giving up capital liquidity? Investors in PE benefit from real value creation. 

In a typical stock investment, your money is not much more than a piece of paper trading hands, fluctuating in value based on a market's perception of quarterly earnings reports, news headlines, and transient economic winds. In PE, your money is put to work scaling companies, funding equipment purchases, securing facilities, and ushering new technologies from development to commercialization. The capital required for these activities is high, and illiquidity is the cost of building real value in a business. Not everyone can afford to take on such liquidity risks, but those that can have an opportunity for above-market returns. That’s why including illiquid assets in a portfolio that also has liquid investment allows for a balanced approach. The liquid portion provides flexibility and immediate access, while the illiquid portion can drive long-term growth and reduce overall volatility.

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Passive investment - letting experts do the work for you

Investing in a PE fund may be more passive than an entrepreneur or active investor might be accustomed to, as PE investors relinquish an active role in selecting private companies stocks or managing the underlying businesses. Those who are used to being able to check their performance daily or are usually involved in the management of portfolio companies may find PE fund investing to be a bit of an adjustment. When investing in PE funds, you put the investing experts to work for you. They assess, invest and support companies to scale for your benefit. 

If you want to be engaged in building a company or selecting promising businesses, a PE fund of funds might not be for you. However, a fund-of-funds structure can provide diversification and expert management - particularly in sectors where your own expertise may not be as deep - with the outsized return potential of PE. And Carbon Equity takes great measures to ensure you are up-to-date on the progress of your investments. Along with the instant diversification of a fund of funds investment, investors can also access our app to see the new companies being added weekly and review quarterly performance.

Building a portfolio that aligns with your values

Like any investment, it's important to weigh the risks and downsides of PE against the potential upsides to make a sound investment decision. In general, investors should strive for a diversified overall portfolio which could include listed equities, direct investment, bonds, PE funds and more. Stick within your risk tolerance, invest with your values, and craft a portfolio that reflects you and you alone.

Interested in Carbon Equity's investment options? Get in touch with our team either through email at invest@carbonequity.com or by booking a call.

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