Consumers at Risk from Unregulated Private-Equity IPOs

September, 2007—Private equity and hedge funds firms have unleashed eye-popping wealth for their owners. But financial advisors should warn their high-net-worth-clients not to assume these wealth-generating engines will enhance their wealth should they participate in a private-equity or hedge-fund initial public offering.

The problem is their fee structures and lack of full disclosure obscure real returns, says Joseph Borg, President of the North American Securities Administrators Association. “The structure of these new instruments places investors in a vulnerable position, subject to the whims of controlling persons and literally without recourse. In light of the complexity and uncertainty surrounding these instruments, allowing them to be offered to the public without appropriate regulatory protections poses serious risks to investors.”

Borg believes that IPOs such as the recent Blackstone IPO skirt the protections of the Investment Company Act (ICA). Under ICA, a fund must have an independent board of directors who represent the interests of public investors. Borg said that the Blackstone IPO makes no provisions for an independent board.

For Borg, the issue is “how much risk, even when disclosed, should be transferred to the general public. In a perfect world, a careful financial adviser will say Blackstone type entities are too risky, too opaque, and too conflicted so we wont’ invest. However, the real world operates much differently.”

Part of the reason for the real world’s enthusiasm for private equity is the strong returns such deals often generate. According to Thomson Financial, private equity deals produced a 13.9% annualized returns over the 20-year period ending in 2006 vs. 9.2 percent for the S&P 500 over the same period. With recent uncertainty in the stock markets, private equity is likely become even more attractive to clients.

So for financial advisors with high-net-worth clients, caution should be the watchword when evaluating private-equity IPOs—and private-equity deals in general. Although wealthy clients often push to participate in such deals, advisors should do their due diligence, making sure they pose reasonable risks.

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