Derivatives/Alternative Investments

The investment committee of a pension fund is considering an investment in a private

equity fund for the first time. As an analyst, you have been requested to discuss the
benefits and drawbacks of investing in a private equity fund during the next committee.
You are required to prepare a memo of around 1,000 words, summarising your research.
A private equity fund raise funds from institutions and wealthy individuals so as to invest that
fund in other types of assets. The main objectives of private equity is to give companies for
example startups another alternative to access to fresh capital. The main investors are
institutions like investment funds, pension funds, endowment funds, insurance companies,
banks, and high net-worth individuals. There are different types of investments as follows:
Leveraged buyouts, Distressed funding, Venture capital funding and Growth capital.
The way that private equity works out is as follows:
1. First of all the private equity fund will raise capital like here they will get fund from the
pension fund so as to build the private equity fund. Once enough money has been
raised, the fund will be closed to new investors.
2. After that the private equity fund manager will start looking for a portfolio of private
companies to invest the fund. They will actually searching for companies that are in a
rapid development and growth phase to invest in. Private equity funds normally make
medium to long term investments of around- years in companies with high growth
potential as the main objective in the long run is to generate enough profit from the sale
of the investment.
3. By investing in these new companies, the private equity firm will also try to improve
efficiency, boost up cash flow, reduce costs, and grow the business by advising on
strategy and development as the next step is the selling of these companies so as to get
a good return on investments.
Investing in a private equity fund has many benefits as well as some criticisms which we will
discuss below.
The main advantages are as follows:
1. Greater diversification of investments portfolio.
The private equity fund invest in many different phases of industry sectors and thus
spreading the risk of investments. In fact we will get access to a better diversified
portfolios with a private equity fund if we were to invest in our own. Hence we will get a
better improvement in the risk/ reward of our portfolio.
2. The fund manager may invest your money in a very promising business which will be
very profitable in the future and hence a good return on investment.
3. We will have access to a wide variety of deal since most of the larger Venture Capital
and Hedge Funds require minimum investment that are beyond the reach of many
individual investors.
4. Experience and knowledge. The private equity funds have the expertise since they are
active participant on the market and hence are able to obtain crucial market information
on a timely basis.
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 5. The private equity fund can scrutinize the business and all legal reviews of a prospective
investment which would have been very expensive if undertaken by a single investor.
6. We will have access to a wide high quality of funds which are managed by a
professional team.
However investing in a private equity fund also have some drawbacks which we are going to
point out:
1. Managerial skills of the private fund manager in decision making to invest in profitable
companies.
We understand that we are investing the money of pensioner’s fund who have saved this
money for lifetime and wish to get a good return on their investment to live a peaceful life
in the future. Therefore the main risk is to avoid making investments which will turn bad
and starting making losses. In order to mitigate this, we have chosen a private equity
fund that have the necessary specific expertise in terms of managerial, financial etc to
develop risk management processes and risk‐mitigation strategies to deal with the
issues inherent in the investment process. Before investing your money they will make a
pre risk assessment by for example analyzing the financials of the companies so as to
ensure that your money is well protected since the investment success has a direct
impact on all stakeholders.

2. Lack of information and behavioral issues

The management or owner in the companies in which your money have been invested
may have more information on their businesses than the fund manager since they have
been working there for a longer period and hence have superior information. This may
lead for example misrepresentation by the manager/ owner of these companies or
difficulty to support all shareholders’ interest which will may lead to poor decision-making
and failure in investment decisions by the fund manager. Moreover the fund manager
may also focus more on the future risk rather than historical information when
conducting due diligence on high risk investments. All this may have a direct impact on
the investment decisions of the fund manager.

3. Use of Financial information

Normally it is easier to gather more information for larger firms due to availability of financial
data and their financial statements are audited which gives trust to the fund manager
compared to smaller ones. Therefore it is much easier to forecast and use of relevant of
information for well-established and mature firms rather than startup .Investing in startup will
depend very often on the intuition of the fund manager and hence understanding the
behavior of fund manager and how use of audited financial statements and adjusting
projected revenue in the pre investment process is important. The fund manager may for
example be more reward oriented as good investments will meant high commissions and
hence do not do a thorough due diligence on the company. Improved decision processes
should ultimately lead to less investment decision failures on the part of the fund manager

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 4. Investing in an equity fund will also mean that your money will be tied up for a longer
period and you will also do not have any say on how your funds is being managed as you
will be at the mercy of shareholders to buy or sell some shares.

5. We will need to pay additional charges for asset management which can reduce the
profits and total returns.
However even with all the negative aspects, investing in private equity fund, remains a good
alternate investment instrument since we will have access to a wide diversify asset class
portfolios managed by a pool of professionals with good knowledge of the market which will help
us maintain a healthy returns if we were to invest in private equity as a single individual.

References
Material Reference List /Bibliography
Internet and EBook Investing In Private Equity: Pros And Cons by David
Merkel

Investopedia
The use of financial information by private equity funds
in evaluating new investments by Jan Smolarski 
Neil Wilner and Weifang Yang 22 February 2011

The Strategic Secret of Private Equity by

Felix Barber and Michael Goold
September 2007

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