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A Guide To Investing in Private Equity and Private Real Estate Funds
A Guide To Investing in Private Equity and Private Real Estate Funds
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investment, usually through the sale of the company to an acquirer or in a public
offering of the portfolio company stock. The proceeds of these sales are generally
distributed to the private equity fund’s investors.
Private real estate investments are typically made through private equity real estate
funds. These funds usually have a seven- to ten-year life span consisting of a two- to
three-year investment period where properties are acquired, then a holding period
where active asset management is carried out and the properties are sold. These
funds will generally have more flexibility than a real estate mutual fund in the types
of investments they make. For instance, private real estate funds may include private
direct real estate investments in multiple property types (such as multifamily housing,
commercial, retail or industrial), “REITs” (real estate investment trusts), debt
instruments or derivatives.
Capital commitment. In a private equity or private real estate fund, the fund’s
managers can seek capital from a number of institutional and/or high net worth
individual investors through “capital commitments,” which can be a fairly large
investment. A private equity or private real estate fund is generally a closed-end fund,
which means that, after one or more fundraising stages (called “closings”), new
investors are not accepted. A fund will not launch if it does not receive a minimum
level of capital commitments.
Capital calls. For the most part, private equity and private real estate funds are
“needs-based” investments. This means that partners of the fund will commit to
giving the fund manager installments of capital, up to a predetermined dollar amount,
on an as-needed basis. As investment opportunities are identified, the fund’s managers
will send investors a formal notice to submit the money they have committed to the
program. This formal notice is referred to as a “capital call” and is a contractual
obligation that each partner must satisfy.
A private equity or private real estate fund’s offering documents typically provide
a number of potential actions against investors who fail to meet capital calls. For
example, a fund may require defaulting investors to forfeit entire ownership interest in
the fund and offer the other fund investors the ability to purchase the forfeited interest.
Capital distributions. Over the long term, the investments in companies that the
managers make in the portfolio may become a realized profit to the fund if those
privately held companies are sold, merged, recapitalized or brought to the public
market at a higher value. If the fund makes such a profit, the private equity or private
real estate fund will typically dispense those proceeds to its partners on a pro-rata basis
through a capital distribution. This is how investors are paid for their involvement in
the fund.
Managers of private equity and private real estate funds may also choose to withhold
capital distributions as a way of reducing the total amount of future funding required
by its individual partners. In other words, if the program’s investors have not fully
funded the partnership up to their total committed amounts, the amount on the next
capital call will be reduced in direct proportion to the withheld capital distribution.
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Private equity investment strategies
There are many different strategies associated with private equity investments. The
most common strategies include leveraged buyouts, venture capital, special situations
and mezzanine financing. Managers who specialize in some of these strategies may
also target the application of their investment dollars and expertise over a number of
different points in a company’s life cycle. Such points might include early seeding,
start-up, expansion or replacement capital.
Leveraged buyouts (LBO). A buyout occurs when a private equity fund or company
takes control of another company’s assets and/or operations by purchasing a majority
of the voting stock of the target company. A “leveraged” buyout (LBO) occurs when
a considerable amount of the proceeds used to make the purchase of the portfolio
company’s equity come from borrowed capital. In some cases, the acquiring body in
an LBO may pledge the assets of the target company as collateral to secure the loan.
Venture capital (VC). This is a term used to describe early-stage investing, when a
fund invests in small businesses or start-up companies that demonstrate above-average
growth potential. Portfolio companies in a VC fund can often benefit from the
specialized skill sets and managerial expertise of the VC fund’s managers.
Special situations. This strategy involves investing in a company based on the belief
that its value will go up due to a specific anticipated event related to the company. Such
events may include shifting industry trends or changing government regulations.
Often viewed as the last sequence in financing before an IPO, mezzanine financers
hope for capital appreciation resulting from a successful initial offering of the
company’s shares to the public.
Early seeding. Sometimes referred to as “seed capital,” investors at the earliest level
of a company’s life cycle are often providing the initial financing to fund a business or
project that is currently at the concept stage. Private equity managers who invest at this
level often provide funding for market research and/or testing for proof-of-concept to
determine the feasibility of the planned business or project.
By providing funding for concept research, private equity managers are taking on the
highest levels of risk while hoping to benefit from the potential growth that ground
floor ownership occasionally provides should these companies and/or projects succeed.
Start-up. Most companies in the initial or “start-up” phase of their development life
cycle have yet to make a profit. These companies may be either just forming as a brand
new company, or they may be newly formed, but have probably not sold or marketed
any of their products. Emerging companies such as these may benefit from the
investment of private equity managers who, in addition to infusing vital capital, may
also be able to provide expertise to help these start-ups bring their products to market.
Characterized as high risk, private equity managers may participate at this level with
the hopes of making a potentially large return on their investment as these companies
grow and become profitable.
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Expansion. As companies enter their adolescent period, they could be starting to make
profit, but they may need additional capital to grow and mature. Therefore, private
equity investors may choose to infuse capital at this stage of a company’s life cycle
to help grow production capacity and/or increase the company’s ability to market the
product. Some private equity managers seek rescue candidates for whom the additional
financing could create a turnaround investment situation.
Although expansion capital carries unique risks, this category is generally considered
to involve less risk than the others, because it typically focuses on established
companies rather than the early seeding or start-up financing of new companies. Any
potential appreciation in value for private equity managers in expansion financing
comes from internal appreciation of the target companies.
“Absolute” returns. Most private equity and private real estate funds seek to achieve
positive or “absolute” returns regardless of the market environment (rather than
merely striving to “beat” or outperform a market index). It is important to note that, in
seeking to achieve an absolute performance, funds may use sophisticated and high-risk
investment strategies. Private equity and private real estate funds may also use
incentive-based compensation, such as “carried interest” (a share of any profits that
the general partners receive as compensation), as encouragement for managers to
achieve annual net cash returns.
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Use of leverage. Private equity managers can structure the debt of their portfolio’s
companies in a manner that may expand earnings and create increased shareholder
value. This is particularly true in buyout funds where the private equity managers
may have the ability to exert influence over the companies in their portfolios. Under
these circumstances, private equity funds can apply their expertise to utilize a full
range of company-specific borrowing options ranging from senior secured debt to
high-yield debt.
Because the individual companies within the portfolio rather than the fund itself
employ these strategies, the private equity manager has effectively safeguarded each
company from the default risk of the others. The intended result for investors would
be the enhanced potential returns of a leveraged portfolio and less downside risk than
would be experienced if leveraged at the fund level.
Private real estate funds may employ leverage as a means to enhance returns, but
leverage is typically not the exclusive investment strategy. The potential benefit
of leverage is that it can increase buying power while amplifying investment returns.
Leverage also increases risk, because it magnifies negative returns if investments
are poorly underwritten or executed and/or market conditions deteriorate. Leverage
should be viewed as a way to potentially improve returns on an already sound
investment strategy.
Historically low correlation* to traditional asset classes. Private equity and private real
estate funds generally attempt to provide returns independent of (or not correlated to)
traditional asset classes. As a result of the low correlation to traditional asset classes,
investments in private equity or private real estate securities may increase the
diversification of an overall portfolio.
Investor characteristics
Suitability. Private equity and private real estate funds are not suitable for all investors.
Prospective investors are required to meet minimum financial eligibility guidelines
(typically “accredited investor” or “qualified purchaser” requirements) to invest in
private equity or private real estate funds. You should evaluate your individual financial
condition and your ability to tolerate risk before you invest in these funds.
Because private equity and private real estate funds are not registered with the SEC,
they can offer or sell securities to only certain types of individuals known as “accredited
U.S. individual investors.” Accredited investors are defined as an individual with at
least $1 million in individual or joint net worth or individual annual income of at
least $200,000. Also included are couples with combined annual income of at least
$300,000 for the past two calendar years, with the reasonable expectation that
the income will continue in the current calendar year. Sales are also allowed to an
“accredited U.S. institutional investor,” which is defined as someone who has at
least $5 million in investable assets.
*Correlation is the tendency for the returns of two assets to move together relative to their average. The
measurement can range from –1 (perfect negative correlation, one goes up the other down) to 1 (perfect
positive correlation, both moving in same direction). A correlation of 0 means no relationship can be found
between the movements in the assets’ performance.
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Though requirements may vary by fund, some offerings at Wells Fargo Advisors may
require investors to meet U.S. Security and Exchange Commission (SEC) guidelines
of a “qualified purchaser,” which require that U.S. individual investors have at least
$5 million in investable net worth in order to be eligible to invest in a private equity
or private real estate fund. U.S. entities should have at least $25 million in
investable assets.
In the case of offshore private equity or private real estate funds and other unregistered
funds, the financial eligibility requirements may be lower than those listed above.
Diversification. Wells Fargo Advisors believes that investors should diversify their
investments. It is recommended that investors observe an asset allocation strategy
and not overweight their overall portfolio in any one class of securities, particularly in
private equity or private real estate funds. Although asset allocation can be an effective
investment strategy, it cannot eliminate the risk of fluctuating prices and uncertain
returns.
Risks
Long-term investment. Unlike mutual funds, which generally invest in publicly traded
securities that are relatively liquid, private equity funds generally invest in large
amounts of illiquid securities from private companies. Depending on the strategy used,
private real estate funds will have illiquid underlying investments that may not be
easily sold, and investors may have to wait for improvements or development before
any redemption. Given the illiquid nature of the underlying purchases made by private
equity and private real estate managers, private equity and private real estate funds are
considered long-term investments. Private equity funds are generally set up as 10- to
15-year investments with little or no provision for investor redemptions. Private real
estate funds are generally seven- to ten-year investments and also have limited
provisions for redemptions. With long-term investments, you should consider your
financial ability to bear large fluctuations in value and hold these investments over
a number of years.
Difficult valuation assessment. The portfolio holdings in private equity and private real
estate funds may be difficult to value, because they are not usually quoted or traded on
any financial market or exchange. As such, no easily available market prices for most
of a fund’s holdings are available. Additionally, it may be hard to quantify the impact
a manager has had on underlying investments until those investments are sold.
Lack of liquidity. Private equity and private real estate funds are not “liquid” (they can’t
be sold or exchanged for cash quickly or easily), and the interests are typically non-
transferable without the consent of a fund’s managing member. As a result, private
equity and private real estate funds are generally only suitable for sophisticated
investors who have carefully considered their financial capability to hold these
investments for the long term.
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Capital call default consequences. Answering capital calls to provide managers
with the pledged capital is a contractual obligation of each investor. Failure to meet
this requirement in a timely manner could elicit significant adverse consequences,
including, without limitation, the forfeiture of the defaulting investor’s interest in
the fund.
Leverage. Private equity and private real estate funds may use leverage in connection
with certain investments or participate in investments with highly leveraged capital
structures. Although the use of leverage may enhance returns and increase the number
of investments that can be made, leverage also involves a high degree of financial risk
and may increase the exposure of such investments to factors such as rising interest
rates, downturns in the economy or deterioration in the condition of the assets
underlying such investments.
Lack of transparency. Private equity and private real estate funds are not required to
provide investors with information about their underlying holdings or provide periodic
pricing and valuation information. Therefore, you are often putting your complete trust
in the managers’ abilities to meet their funds’ objectives, without the benefit of knowing
their investment selections. This lack of information may make it more difficult for
investors to evaluate the risks associated with the funds.
Manager risk. Private equity and private real estate fund managers have total
investment authority over their funds, and the managers’ skill is normally responsible
for the investment returns. Therefore, if the founder or key person departs, the returns
of the fund may be impacted. Investors have no control or influence in the management
of the fund, although they will receive periodic reports from the fund manager. Also,
your investment in one fund that uses a generally similar investment strategy as
another fund could lessen your overall diversification, and consequently, increase
your investment risk.
Regulation. Private equity and private real estate funds are subject to fewer regulatory
requirements than mutual funds and other registered investment company products
and thus may offer fewer legal protections than you would have if you invested in
more traditional investments.
Tax treatment
Generally, investors in private equity and private real estate funds are subject to income
taxes on the income and/or capital gains distributed to them from those funds. In some
years, investors’ tax liabilities may exceed any distributions received from the funds.
Additionally, investors may be subject to various limitations on their ability to use their
allowable share of deductions and losses from the funds (for example, passive loss
limitations, investment interest limitations, capital loss limitations and limitations
on the deductibility of miscellaneous itemized deductions).
In retirement accounts such as IRAs, taxes are deferred until distributions are taken
from the account. Investors using retirement accounts or tax-exempt entities, such as
endowments or foundations, need to be aware that private equity and private real estate
funds may produce unrelated business taxable income (UBTI), which may subject
the retirement plan or tax-exempt entity to taxation. In instances where tax-sensitive
private equity and private real estate funds are available, retirement account or
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tax-exempt investors are encouraged to consider the potential advantages of using
such funds for their private equity and private real estate allocation. Investors should
consult with their tax advisors to consider the potential impact of UBTI.
Private equity and private real estate funds are highly tax-inefficient vehicles and
should be scrutinized for tax consequences before an investment is made. There are
a number of adverse tax consequences that should be taken into account when
considering an investment in private equity or private real estate funds. Most are
organized as limited partnerships (LPs) or limited liability companies (LLCs). Because
of their structures, a “pass-through taxation” strategy (taxes are “passed through”
the owners, who then report loss or income on their personal income tax returns) is
achieved. All domestic private equity and private real estate funds send their investors
Schedule K-1 tax statements, which are typically issued later than 1099s. For this
reason, investors may need to file a tax extension for every year of involvement
with the fund.
Wells Fargo Advisors is not a tax and/or legal advisor. Because of the complex tax
reporting requirements associated with private equity and private real estate funds,
investors should consult with their tax advisor or attorney before investing.
All expenses are disclosed in the fund “offering documents” (documents provided by
a fund that explain its objectives, risks, terms of investment and other policies), and
you should be aware of these expenses. Typical expenses include, but are not limited to,
the following:
Annual management fee. Investors are charged an annual management fee on the
value of their investment. This fee is the cost of a fund manager making the investment
decisions for you. The fund manager typically receives a fee of 1% to 2% of net assets,
although this amount depends on various factors, including the type of fund. Where
revenue-sharing arrangements are in place with fund managers, Wells Fargo Advisors
may receive a portion of this fee to compensate its Financial Advisors.
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As an example, assume that a private equity fund has a carried interest charge of 20%
and a pre-established 8% hurdle rate. A total return of 10% (net of management fee)
by the fund in any given year would entitle the manager to collect 20% (performance
incentive fee) on 2% of the profits or, in other words, those returns that were in excess
of its 8% hurdle rate. This would result in a total net return to investors of 9.6%. A
performance fee, such as the one described, could motivate a fund manager to take
greater risks in the hope of generating a larger return and, in turn, receiving a
higher fee.
Placement fee. The placement fee is a front-end sales charge (a sales charge that must
be paid immediately upon purchase) paid to the placement agent. In turn, the agent
may pay a portion of those fees to affiliated or unaffiliated registered broker-dealers or
other entities involved in the offer and sale of the private equity or private real estate
fund interests. Wells Fargo Advisors receives a portion of the placement fee to
compensate its Financial Advisors.
The compensation formula that determines the amount of payment to your Financial
Advisor is generally the same for all funds. However, some funds may carry higher
sales charges than others, which may create an incentive for the Financial Advisor to
recommend those funds.
Within the division that operates in Wachovia* financial centers and some Wells Fargo
stores, a Licensed Banker (LB) may refer you to a Financial Advisor, as they generally
work as a team. In this case, the LB will be compensated through a referral arrangement
with the Financial Advisor.
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Additional information Additional compensation received by Wells Fargo Advisors
Determining whether private equity or From fund sponsors
private real estate is an appropriate
investment strategy for you requires an At Wells Fargo Advisors, we receive payments from some of the companies whose
in-depth evaluation of your individual private equity and private real estate funds we offer. These payments may be used to
financial situation and the objectives pay for training, educational conferences, meetings for our Financial Advisors, and
you want to achieve. Talk to your meetings for our clients or prospective clients, as well as for conducting “due diligence”
Financial Advisor today about how (an investigation or audit of a potential investment) on the funds. The payments also
private equity and private real estate
provide marketing support, which is usually calculated as a percentage of fund sales
funds may help you work toward your
investment goals, or visit the following or assets.
Web sites: These amounts are not part of the compensation formula for your Financial Advisor.
Wells Fargo Advisors We believe that these financial arrangements do not compromise the advice your
wellsfargoadvisors.com Financial Advisor offers you. Additionally, these arrangements do not affect your
Financial Industry Regulatory Authority sales charge.
finra.org Private equity and private real estate fund policies can be found in a fund’s offering
U.S. Securities and Exchange document, which is available on request from the fund company. Certain private equity
Commission fund sponsors paid Alternative Strategies Group, Inc., who in turn paid Wells Fargo
sec.gov Advisors and/or Wells Fargo & Company in 2009 for marketing and/or other
service fees. If you have any questions about these practices, please contact your
Securities Industry and Financial
Markets Association Financial Advisor.
sifma.org
From other fund relationships
Wells Fargo & Company (Wells Fargo), one of the largest financial holding companies
in the United States, provides a wide range of financial services to various private
equity and private real estate fund companies through its subsidiaries and affiliates,
including Wells Fargo Advisors. These other relationships provide financial and other
benefits to Wells Fargo and Wells Fargo Advisors. As part of these relationships:
In the course of establishing annual sales targets for business planning purposes,
sales with our affiliates are included in our goals. We intend, however, to make all
recommendations independent of such sales goals and based solely on our obligations
to consider our clients’ objectives and needs.
Private equity and private real estate funds are speculative investments and are not suitable for all investors
and do not represent a complete investment program. There are special risks with an investment in real estate,
including credit risk, interest rate fluctuations and the impact of varied economic conditions. The funds are
usually open to qualified investors who are comfortable with the substantial risks associated with investing in
private equity and private real estate funds. For a more complete description of the risks associated with any
private equity or private real estate fund investment, please read the private placement memorandum or
offering documents or consult your Financial Advisor. This document is not an invitation to subscribe for
shares in any fund and is intended for information purposes only.
Investment and Insurance Products: NOT FDIC Insured NO Bank Guarantee MAY Lose Value
Wells Fargo Advisors is the trade name used by two separate registered broker-dealers: Wells Fargo Advisors, LLC and Wells Fargo Advisors Financial Network, LLC,
Members SIPC, non-bank affiliates of Wells Fargo & Company. ©2010 Wells Fargo Advisors, LLC. All rights reserved.
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