"I ran into a wealthy and influential individual at a local Starbucks a few months ago," recalls Caprice Mallett, president of Biltmore Wealth Advisors in Phoenix. "He asked what I had been up to. When I told him, 'I'm brokering private equity,' that got his attention. Many high-net-worth people are intrigued by private equity."

Mallet snagged this prospect, who became a client and an investor in a late-stage venture deal—and more family money and referrals may be forthcoming. "Mentioning private equity opens doors to conversations with people you may not have been able to talk with," she adds. "If they become clients, the cross-selling opportunities are wonderful."

Why Now?

Why is private equity suddenly on everyone's lips? Mainly because of the stellar returns of the asset class. Overall, private equity returns through 2006 handily topped the S&P 500 for the prior one, three, five, 10 and 20 years. The 20-year numbers, for example, show private equity posting annualized returns of 13.9% versus 9.2% for the S&P 500, according to Thomson Financial in New York. In addition, private equity is only moderately correlated with traditional stock and bond investments, according to the Center for International Securities and Derivatives Markets, a nonprofit research center at the University of Massachusetts Amherst.

Of course not every investor out there will have such great returns from private equity, but it does seem to be a magnet for some high-net-worth clients. If your A-list clients are asking about private equity, here are some of the basics that you will need to know.

Private equity refers to equity capital that is made available to companies or investors, but which is not quoted on a stock market. There are three major kinds of private equity.

Three of a Kind

Buyouts. Most of the recent rich-investors-get-richer articles have involved leveraged buyouts, where investors use borrowed money to acquire a company that's usually an established business, and that will not be publicly traded at the close of the deal. Buyouts may deliver huge returns because they're put together with "other people's money." Buyouts can happen through syndicated loans from big investment banks and institutional investors—secured by the assets of the target company.

Venture capital. These deals typically support young companies. Generally, "seed" or early-stage investments carry greater risks and larger potential returns. Later-stage deals invest in more developed companies and so may be relatively safer.

Mezzanine. These investments fall midway between debt and equity. An interest-bearing loan might be combined with warrants and common or preferred stock.

Despite all of the recent focus on buyouts, venture capital has actually been the superior long-term performer. Thomson Financial shows buyouts returning 8.5% and 12.9%, respectively, for the past 10 and 20 years. Venture capital meanwhile returned 20.3% and 16.6% a year, for the same periods, according to the National Venture Capital Association in Arlington, Va.

Doing the Deal

In a typical private equity deal, the sponsor asks investors to ante up cash commitments periodically. Clients who agree to invest, say, $1 million might receive a capital call for $250,000 once a year for four years. Altogether, the expected holding period might be as long as 10 years.

Minimum investments might be roughly $1 million, or $250,000 for a fund of funds. The most successful private equity funds are geared toward institutional investors and require investment minimums of $5 million or more, says Kelly DePonte, a partner at San Francisco–based Probitas Partners, which raises capital for private equity fund managers. "Funds that accept small investors often have weak track records. Funds of funds that provide private equity access to retail investors often come with fees that are so high that returns suffer significantly."

The LLC Option

There is another way for retail clients to get better deals. Jason Cole, a managing director with Abacus Wealth Partners in Philadelphia, tries to find deals for clients that let him in for less than $1 million. "We ask sponsors if they will agree to accept money from our clients on an aggregate level," Cole says. "Suppose a sponsor wants a $2 million commitment from our firm; if the sponsor will accept such an arrangement, we'll set up a limited liability company (LLC), where the minimum per client might be $50,000. The lower minimum investment allows clients to be in more deals, for more diversification." His LLC invests in numerous offerings and investors may get in on different deals and returns depending on when they invest in the LLC.

Homrich & Berg, a planning firm in Atlanta, has used two separate LLCs to create two proprietary funds of private equity. "We did one in 2000 and another about a year-and-a-half ago," says Chief Executive Officer Andy Berg. The firm offered selected clients access to a mix of private equity funds through the LLC. Each participating client who invests in one of the firm's LLCs effectively acquires an interest in each of the underlying private equity funds.

"Doing it this way provides better access to good funds than might have been the case with a fund of funds put together by someone else," says Berg. "In private equity, a large part of your success is determined by the people with whom you're investing."

Operational Challenges

Whether the advisor has one LLC that invests in several offerings or multiple LLCs, creating and managing that structure is time-consuming and difficult. The process involves legal and accounting fees, choosing a managing partner and then making sure he or she is performing those duties. "You need to produce reports and show values on those reports," says Cole. "If there are multiple capital calls per deal, that becomes an operational burden for the advisor."

Indeed, the operational challenges may discourage financial planners from offering private equity at all. "From a theoretical perspective, private equity is a nice investment option to consider," says Michael Kitces, director of financial planning at Pinnacle Advisory Group in Columbia, Md. "From a practical perspective, however, it can be extremely costly and difficult to implement in a growing practice with a large number of clients."

Limits on the number of investors per fund might force a large planning practice to participate in or administer several private equity offerings, which would increase the cost and complexity of required paperwork, Kitces points out. One reason that his planning firm doesn't offer private equity is that "many offerings operate outside of the traditional custodial platform, so clients may not see the results integrated with the rest of their investments on our performance reporting."

The Inefficient Frontier

Probitas Partners' DePonte offers further cause to be cautious. "Private equity is a tremendously inefficient market with wide variations in returns among managers," he says. "Making money in private equity is highly dependent on choosing the right funds or fund of funds, not just on getting access. Diversification doesn't necessarily drive success; good managers drive success. The bottom line is that private equity investing simply isn't for everyone."

Abacus Wealth Partners' Cole has known both the good and the bad. He invested clients in a private equity fund sponsored by Greenmont Capital Partners in Boulder, Colo., which focuses on the "lifestyles of health and sustainability" (LOHAS) market. "We got in early in this trend and the fund has returned 56% net of fees in two-and-a-half years," he says. Among the companies his clients invested in were Izze Beverage Co., which was bought by PepsiCo.

But he has had his losers as well. "We went into a private equity fund in 2001 that was designed to help life sciences companies grow, but it turned out that there was too much money chasing those deals and the companies our fund selected haven't done well." Six years later, Cole's clients have received only 13 cents on the dollar, from companies that were backed and subsequently sold; clients' remaining interests in this private equity fund are valued at around 50 cents on the dollar now, with no secondary market in sight.

Finding Mr. Right

If planners have wealthy clients, who are suitable for private equity, how can they find the right deals? "The challenge is getting access to top-tier private equity sponsors," says Mitch Dynan, chief investment officer at Mintz Levin Financial Advisors in Boston. "Predominantly, they focus on institutional investors." Some sponsors come to his firm, but they may not be truly top tier, he says. "The private equity offerings we bring to our clients are a mix of deals that come in and those we have found through our network of friends and clients, who may be high-net-worth individuals."

Scrutinize the sponsor's track record and the background of key personnel, says Dynan. He likes to see a sponsor who has expertise in a particular industry, such as retailers, because that knowledge can be critical in deciding which companies to target. "You might want to avoid investing in a sponsor's first fund," says Dynan. "The money raised may be used to build an organization, to hire analysts and other key people. By the time a second fund is being offered, investors won't have to bear all those costs."

It's All in Who You Know

Planners like Joel Marks, the vice chairman and chief operating officer of Advanced Equities Financial Corp. in Chicago, gets access to deals for clients through one of his firm's broker-dealer subsidiaries, FFP Securities and First Allied Securities. "We help finance companies that have received seed money from top venture capital firms such as Kleiner Perkins Caufield & Byers [located in Menlo Park, Calif.]," he says. "This gives our clients access to institutional-quality products they wouldn't get elsewhere." Generally, financial planners need to be affiliated with one of Advanced Equities' broker-dealers to gain access to such private deals. But some outside registered investment advisors who focus on wealth management have been able to participate through LLCs.

Private Equity for All

And then there is the everyman fund. Anyone can get a foot in the door with PowerShares Listed Private Equity Portfolio (PSP), an exchange-traded fund that was introduced last October. This ETF seeks to replicate an index of publicly traded companies that have direct investments in more than 1,000 private businesses. "We are researching PSP," says Cole. "It's an indirect play. You own the private equity firms rather than the underlying companies. However, it's the only real option for the average investor who wants to access private equity." For planners who want to get into private equity, this would certainly be the easiest way to do it, but it probably won't have the cachet most high rollers are looking for.

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