What are the risks of private equity investments?

Private equity investments carry various risks that are important to understand before entering this asset class. The main risks include limited liquidity due to long commitment periods, sensitivity to market volatility, complex governance structures, and potential conflicts of interest between investors and fund managers. Although private equity historically can generate attractive returns, it’s essential to carefully weigh these risks against your own investment goals and risk tolerance.

What are private equity investments?

Private equity investments are investments in non-publicly listed companies or in businesses that are being taken private. With this investment form, investors directly purchase shares in private companies or participate through specialized funds managed by private equity firms.

The key players in this market are private equity managers, institutional investors (such as pension funds and insurance companies), and high-net-worth individuals. These investors pool their capital to buy companies, restructure them, and ultimately sell them at a profit.

Companies and investors choose private equity for various reasons: businesses gain access to capital and strategic support, while investors aim for above-average returns and portfolio diversification. Minimum investment amounts are typically high, and investment terms usually range between 5 and 10 years.

What is the liquidity risk in private equity?

Liquidity risk is one of the most characteristic challenges of private equity investments. Your money is locked up for an extended period – typically 7 to 10 years – without the possibility of early exit. This is known as the lock-up period.

Unlike publicly listed stocks, there is no active secondary market where you can easily sell your interests. Although a secondary market for private equity interests exists, it is less developed, and sales are often made at a significant discount.

This lack of liquidity can be problematic if you unexpectedly need access to your capital. For companies operating internationally, it’s therefore important to integrate liquidity planning into their broader financial strategy. Using multi-currency IBAN accounts can help you manage liquidity efficiently across different currencies.

How does market volatility affect private equity returns?

Market volatility has a significant effect on private equity investments, despite many people believing these investments are less sensitive to market fluctuations. In reality, valuation methods and exit opportunities are directly influenced by broader economic conditions.

During economic downturns, the following issues can arise:

• Lower valuations when selling portfolio companies
• Fewer available exit options (such as IPOs or sales to strategic buyers)
• More limited access to debt financing, which can reduce returns

At the same time, private equity managers can sometimes leverage opportunities during market volatility by acquiring companies at lower valuations. The cyclical nature of economies means that investment and exit timing are crucial for ultimate returns.

What governance risks play a role in private equity?

Governance risks represent an underestimated aspect of private equity investments. As an investor, you have limited control over the actual investment decisions, which are primarily made by the fund managers.

This can lead to various challenges:

• Limited transparency regarding the actual performance of portfolio companies
• Potential conflicts of interest between fund managers (who aim for management fees) and investors (who aim for returns)
• Complex fund structures that provide less insight into costs and fees

To mitigate these risks, it’s important to conduct thorough due diligence on the reputation, track record, and governance structure of the private equity fund you’re considering investing in.

Key considerations for private equity investments

When considering private equity investments, there are several important factors you shouldn’t overlook:

• Diversification is essential – limit your exposure to private equity to a percentage that aligns with your risk profile
• Pay attention to the expertise and track record of the management team
• Fully understand the fee structure, including management fees and carried interest
• Consider your long-term liquidity needs
• Evaluate the fund’s investment strategy and how it aligns with market conditions

For companies operating internationally and investing in private equity, effectively managing currency risks can pose an additional challenge. At TaperPay, we understand this complexity. Our multi-currency IBAN accounts enable you to manage investments in different currencies without the need to set up foreign bank accounts. This not only simplifies your administrative processes but also protects against unnecessary currency exchange costs and risks with international payments.

By carefully evaluating the above risks and considerations, you can make an informed decision about whether private equity fits within your broader investment strategy and international financial activities.