Private Equity: Greater Returns, Greater Risks

"There's really no reason why investors or clients need to have all their capital liquid all the time," Brown says, providing as an example purchasing a house that is largely an illiquid investment.  He adds there are short-term lockup period funds, as short as one year, noting the lockup time depends on the fund's strategy.

Lawrence Calcano, managing partner at iCapital Network, says that lockup periods associated with PE funds "are one of the largest issues that people have to grapple with before investing. But stepping back, there's a real reason for the lockup periods…. For example, in the case of a buyout, the process of improving value in the underlying portfolio company takes time. If near- term liquidity is important to you, then private equity is not the asset class for you."

In 2012, TowersWatson published a study on Private Equity Benchmarking and provided recommendations on how to benchmark these funds, including:

• investors/allocators should change a benchmark according to a fund's implementation and goal
• managers should be  matched against their goals and interests
• both long and short term measures should apply
• benchmarks should "incorporate a balanced scorecard approach to ensure a more holistic view of both qualitative and quantitative factors affecting risk and return"

Although firms such as iCapital use Cambridge Associates' PE Benchmark to view the overall private equity returns in the aggregate — the benchmark is derived from performance data compiled for funds that represent the majority of institutional capital raised by private equity partnerships —  the firm drills deeper when performing due diligence on private equity funds, both before and after selection, Calcano says.

"We look at absolute returns, as well as comparisons to appropriate benchmarks that vary by type of fund," Calcano says. That means comparing equity managers against their peers who invest using the same strategy. The focus of his firm, iCapital Network, is on selecting mainly first quartile managers.

If iCapital Network analysts are looking at a buyout fund, for example, it might compare it to the Russell 2000 or S&P 500. They dig into the details of the fund, and determine if returns were due to financial engineering or fundamental improvement in the underlying portfolio companies (which is preferable). Then they use that information write a report that is provided on their platform (and Fidelity platform) so advisors can make educated choices for portfolios, Calcano says.

Does he believe the new investment in private equity funds might dilute the asset class' long-time stellar returns?

"Private equity has been around a long time as an asset class, and historically is an asset class that has largely only been available to institutions and the absolute wealthiest of individuals,"says Calcano.  "Part of what we're really trying to do is democratize the asset class, so that qualified investors will have a chance to invest thoughtfully in it just like institutions do."

 –Related on ThinkAdvisor:

• Big Investors Demand More Transparency From Private Equity — or Else
• Fidelity Institutional Offers Clients Access to Private Equity Funds
• Q1 Private Equity Buyout Deals Contract Sharply – ThinkAdvisor