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Private Equity Funds for the Masses

What investors should know before they dive in.

Nadia Papagiannis, CFA, 04/12/2013

Once reserved for the very wealthy and ultra-patient, illiquid investments such as rare earth metals, defaulted and distressed bonds, and nontraded REITs are increasingly being packaged in liquid wrappers. This movement's latest incarnation is sponsored by the private equity community. Private equity firms including Carlyle Group CG, KKR & Co KKR, Apollo Global Management APO, and Blackstone Group BX, have all either recently filed for or have launched retail products that aim to better diversify portfolios. Before investing in these new products, however, investors must understand the premise of private equity, and the relationship between the liquidity of the underlying investment versus its packaging.

In exchange for locking up your money for seven to 10 years, traditional private equity funds expect to offer a higher rate of return than the listed stock market (this extra return is called a liquidity premium), with a relatively low correlation (as the private and concentrated nature of the investments prevent them from moving closely with the listed markets). Private equity funds largely have met their goal: Cambridge Associates U.S. Private Equity Index, for example, returned twice as much as the S&P 500 between April 1997 and September 2012 (13.6% net of fees versus 6.1%, respectively), with only a 0.78 correlation (using quarterly returns).  

Unfortunately, private equity is largely out of the reach of retail investors, who typically do not meet accredited investor rules, and who typically do not have several million to invest. In 2007, Red Rocks Capital attempted to democratize private equity by launching a listed private equity mutual fund ALPS/Red Rocks Listed Private Equity LPEFX. Five years later, firms like Carlyle, KKR, Apollo, and Blackstone hope to follow suit. These products offer minimum investments as low as $2,500 and range in structure and liquidity terms.

While it's too soon to tell how these investments will fare, some appear better positioned for success than others. Investment vehicles that promise liquidity but whose underlying investments are largely illiquid have a high likelihood of backfiring. Vehicles that promise liquidity and can actually deliver it may be good investments, but their risk/return profile may not match private equity's. Here is a deeper dive into some of these newer products, and the pros and cons for each.

CPG Carlyle Private Equity Fund
In November 2012, Central Park Advisers filed an application for the CPG Carlyle Private Equity Fund LLC. This is a 1940 Act-registered, nontraded, closed-end, interval fund that will invest primarily in other new and existing private equity funds (direct private equity investments are allocated only 0% to 20% of the fund's total assets). The benefit of the fund, according to the filing, is to have "preferred access to investment fund managers affiliated with Carlyle." The fund will be managed by Mitchell Tanzman and Gregory Brousseau of Central Park Group, which is a fund of funds firm the managers founded in 2006.

This fund's closed-end interval structure, while still requiring "accredited investor" status, is accessible for only $50,000 and files quarterly disclosures on its performance and holdings, unlike typical private funds. The fund also anticipates that it will offer quarterly redemptions of up to 5% of the assets of the fund. In order to create this liquidity, the fund has to be creative. It will hold some liquid assets, potentially use leverage (within the limitations specified by the 1940 Act), and invest in secondary offerings of private equity fund shares (which may have shorter holding periods). Finally, the fund will manage liquidity through its "commitment strategy." Essentially, this fund will hold cash that has been committed to underlying private equity funds, but which has not yet been deployed.

While this fund presumably will give investors true private equity exposure, with more liquidity than traditional private equity funds, there are some major risks associated with this type of structure. First, the fees: There are management and incentive fees of 1.00%-1.75% and 20% respectively; a second-layer management fee of 1.20% (with a cap of 0.75% for the first year); operational and offering expenses of the fund of funds and the underlying funds; a sales load of up to 3.50%; and a redemption fee of 2.00% for the first year. Added up, these expenses will take a big bite out of the fund's returns.

Second, there's no guarantee that the fund will deliver on its 5% anticipated quarterly tenders. Investors in Salient's Endowment Registered Fund, a similar closed-end interval fund, learned this the hard way in January 2013, when the fund suddenly stopped redeeming shares. CPG Carlyle Private Equity's application suggests it will use its already committed capital to fund tender offers. It may also "overcommit" its capital to the underlying funds to boost returns, a strategy which could dry up cash intended to fund redemptions. 

Nadia Papagiannis is an analyst with Morningstar.

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