Venture capital, hedge funds, angel investing, private equity – there seems to be a whole world of opportunities beyond the traditional realm of stocks, bonds, ETFs, and mutual funds. Movies often depict flashy investors involved in these kinds of ventures, with seemingly little downsides. And if you have a healthy chunk of cash on hand, the potentially lucrative rewards seem enticing.
Of particular relevance in today’s financial world is private equity, an investment strategy that sees a private equity firm pool money from investors and banks to purchase what it views as an underperforming business, improve its financial performance, and then sell that business for a profit. Those profits then get split between the initial investors and the private equity firm.
How is private equity investing different?
Private equity differs from regular investing in a few key ways. Firstly, the companies that the private equity firm purchases (or purchases a controlling stake in) may not be publicly traded, meaning they are private institutions, such as a family business or LLC. Secondly, the private equity firm typically takes over the company’s management, streamlining its processes, changing management as they see fit, and scrapping any inefficiencies or downsizing as necessary.
Thirdly, PE firms often invest with a longer time horizon in mind. Unlike traditional investors who might buy and sell shares within a day, week, or a few months, PE firms typically hold their investments for several years, meaning assets are highly illiquid.
Fourthly, private equity investments are often characterized by high levels of leverage. PE firms commonly use debt to finance a significant portion of their acquisitions. This strategy can boost returns if things go well but also increase the risk of losses.
Private Equity is a Massive Business
The private equity business is booming – more than 4 trillion dollars is wrapped up in private equity, double that of just ten years ago, and it’s easy to see why. The potential for massive profits is incredible; just look at Silver Lake, a private equity firm that purchased Skype for about 2 billion dollars and sold it just a couple of years later for 11 billion dollars. Or Blackstone’s massive profit after buying the distressed Hilton franchise in 2007, ultimately making over 14 billion dollars. Other success stories include Intel, Dell, and Cisco, all household names that, in saw way or another, owe their status to private equity.
High Minimum Investments
Of course, these are huge figures, which also means there’s an incredibly high barrier to entry when it comes to private equity investing. In fact, you’ll be hard-pressed to find an investment opportunity of less than a few million dollars, making most private equity investments firmly in the Ultra High Net Worth realm.
If you happen to be an Ultra-High-Net-Worth investor, you must know the risks of private equity investing. Yes, the growth potential is enormous, especially if you are lucky enough to get in with a company prior to a successful IPO. However, you also run the risk of a 100% loss of investment, just like with nearly every investing opportunity. You also face concentration risk – putting millions of dollars into a single investment is the opposite of diversification unless you’re a billionaire capable of diversifying your portfolio with individual investments worth millions of dollars each.
Private Equity Fund of Funds
To avoid concentration risk, you can invest in funds of funds, which provide diversification while still providing you with the lucrative opportunities typically available to institutional investors. This is accomplished by pooling money from investors to invest in several private equity firms rather than just one deal.
Let’s use some examples to compare to a traditional private equity fund.
Traditional Private equity fund
Company A is a private equity firm that pools funds from individual investors to buy Corporation B for $500,000,000 and bring it private. The minimum investment is $50,000,000 from each investor, meaning this game is only for the bigwigs. Upon purchasing Corporate B, they turn around the company (while charging a management fee) and then sell it for a profit, with a chunk of profits staying in the firm and the rest being divvied to investors.
Private equity fund of funds
Company B is an LLC that pools investors’ money together to invest in Company A and possibly other companies. The minimum to invest in Company A is $50,000,000, so they find 100 investors who can put in $500,000. Company B gives its own investors their share when the profit is finally realized. Oh, they also earn a management fee, revealing one of the most significant issues with Funds of Funds: high expenses. You’re essentially paying the management fee twice.
The question you must ask yourself is will the profit be high enough to more than cover both management fees and still outperform traditional investments, like ETFs and Mutual Funds? Possibly yes, possibly no – it’s up to you to perform the due diligence necessary to make that determination or partner with a financial advisor to help you make an educated, experienced, and informed decision.
Alternative ways of investing in private equity
Funds of Funds are still expensive affairs, proving a still very high barrier of entry for your average American investor. However, in recent years, private equity has been gradually democratized, with new platforms and funds providing more access to individual investors.
These include:
Crowdfunding Platforms
Sites like CircleUp, StartEngine, and EquityNet allow individual investors to invest in private companies with much lower minimums, often starting from a few thousand or even a few hundred dollars.
Private Equity ETFs and Mutual Funds
Some ETFs and mutual funds, like those offered by iShares, aim to replicate the performance of private equity investments. These come with lower minimum investment requirements typical of ETFs and mutual funds.
Business Development Companies (BDCs)
These are publicly traded companies that invest in small and mid-sized businesses. They operate similarly to private equity firms but are accessible to individual investors. Examples include Ares Capital Corporation and Prospect Capital Corporation.
Real Estate Crowdfunding Platforms
For those interested in real estate private equity, platforms like Fundrise, RealtyMogul, and CrowdStreet have lower investment minimums, often starting from $500 to $5,000.
In Conclusion
Private equity is most likely not suitable for most investors. The risks associated with it are simply too significant, namely an enormously high barrier to entry, long periods of illiquidity, and risk concentration. Only individuals with extensive experience, wealth, and a stomach for risk should consider getting into private equity.
That being said, recent developments in the financial sector have begun to democratize access to private equity investments, lowering the barrier of entry through crowdfunding platforms, ETFs, mutual funds, and BDCs. These alternative methods could allow everyday investors to explore the benefits of private equity without needing millions in their banks.
Ultimately, whether you are an Ultra-High-Net-Worth investor, an accredited investor, or an average individual seeking new investment opportunities, it is essential to carefully consider your financial goals, risk tolerance, and investment horizon with a financial advisor before venturing into the domain of private equity.
