Risks of Investing in Private Equity
What risks are associated with investing in private equity? We can classify the risks coming from investing in private equity into several categories. Firstly, we have so-called general private equity risk (which we will discuss on this page). Secondly, there are the risks that are specific to the investment strategy, risks related to the industry, risks specific to the investment vehicle, and regional or country risk.
On this page, we focus primarily on the general private equity risks that investors that are considering private equity should be aware of. We also briefly discuss the costs of private equity investing. This is another important aspect of private equity investing that potential investors should be wary about.
General risk factors in private equity
The general private equity risk covers at least the following set of factors:
- Liquidity risk: private equity investments, unlike public equity, are not publicly traded. As a consequence, it may be very difficult to liquidate a position.
- Capital risk: unexpected increase in business and financial risks may result in a withdrawal of capital. Portfolio companies may find it difficult to obtain additional funding.
- Market risk: Private equity is sensitive to structural changes to long-term interest rates, exchange rates, and other market risks. Short-term business market fluctuations are usually not significant risk factors.
- Unquoted investments risk: Because private equity investments do not have a publicly quoted price, they may be riskier than publicly traded securities. That’s because there is more uncertainty on the fair price.
- Agency risk: the managers of portfolio companies (that is, the companies the private equity company is invested in) may not act in the best interests of the private equity firm and its investors
- Regulatory risk: The portfolio companies’ products and services may be adversely affected by government regulation. This is also a risk when investing in public equities in sensitive sectors.
- Valuation risk: The valuation of private equity investments reflects subjective, not independent, judgment.
- Diversification risk: Private equity investments may be poorly diversified. It is very important that investors try to diversify across investment development stages, vintages, and strategies of private equity funds.
- Tax risk: Finally, the tax treatment of investment returns may change over time. This is hard to anticipate since it depends on politics.
Costs of private equity investing
The costs of investing in private equity are significantly higher than with publicly traded securities. Private equity costs include at least the following:
- Transaction costs: transaction costs include costs from due diligence, bank financing, legal fees from acquisitions, and sales transactions in portfolio companies.
- Audit costs: These are generally fixed and recurring annually.
- Management and performance costs: Performance fees are typically higher than that for other investments and are commonly 2% for the management fee and a 20% fee for performance.
- Dilution costs: Additional rounds of financing and stock options granted to portfolio company management will result in dilution of ownership of the private equity firm.
- Placement fees: Placement agents who raise funds for private equity firms may charge up-front fees as much as 2% or annual trailer fees as a percent of funds raised through limited partners.
- Investment vehicle fund setup costs: The legal and other costs of setting up the fund are usually amortized over the life of the fund.
- Administrative costs: These are charged on a yearly basis and include custodian, transfer agent, and accounting costs.
We discussed the risks of investing in private equity.