In our recent blogs on Asset Allocation and Portfolio Diversification we covered the most common investment categories. Today we are going to talk about a very important alternative investment that falls outside of the conventional realm. We’ll talk about the pros and cons to investing in private equity. Private equity investments fall outside of the common investment categories because of their complex nature, lack of regulation, and degree of risk.
But what exactly is private equity?
Private equity is capital used by investors to invest in or to buy out public companies. This capital can then “… fund new technology, make acquisitions, expand working capital, and to bolster and solidify a balance sheet.”
Generally 99% of the shares of a private equity is owned by Limited Partners (LP), or silent partners. They might be part-owners, but are not involved in the day to day operations of the company. The other 1% is owned by General Partners who are responsible for executing and operating the investment.
High-net worth individuals could easily consider including private equity in their investment portfolios. However, it’s important to understand both the advantages and risks of holding these types of investments.
The Pros and Cons of Investing with Private Equity
One of the reasons to take on the high risk of this type of investment is that private equity investments can generate incredibly high returns. Looking at a private equity investment that generates higher net returns than a traditional asset class? You’ve found what you’re looking for.
When used as part of an investment strategy, private equity can provide substantial diversification benefits. This asset class opens investors up to new opportunities. These include companies too small or unsuitable for listed markets, plus early stage and growth capital businesses. Private equity is also able to provide better access to listed equity markets, especially in emerging markets.
Private equity investments are typically long term. So if you have a time horizon of ten years or more, this is an acceptable factor. They are also illiquid — meaning you cannot sell them easily or quickly for cash without losing value. Hence, if you have a shorter time horizon and a need for liquidity, this type of investment is not for you.
If you are willing to wait out the J-Curve effect , this is a great investment opportunity for you. Typically private equity investments will start out with negative cumulative cashflows.
In the beginning, capital is drawn down for new investments and fees are paid on the committed capital. As investments mature, the cumulative cashflows will start to turn around and investors will receive distributions from the sale or exit of their private equity investment. You’ll need some patience, as it could take several years for you to have a clear assessment of performance. Hence if you are short of patience and time, this is not the investment class for you.
How Much Risk Comes with Investing in Private Equity?
Compared to listed equities market, private equity investments generally tend to have lower price volatility. This lower volatility is due to the frequency of valuation, which tends to range from quarterly to annually. But don’t confuse lower price volatility with lower risk.
Be aware that the rights of private equity shareholders are generally decided on a case-by-case basis.
You will also need to tolerate higher fees than you may be used to. Private equity fee structures are significantly higher than other traditional asset classes. Management fees on committed capital typically come in at 1.5% to 2.0%. In addition, there is a performance fee of around 20%. There are even more fees if you are investing through fund structures.
The buy-in on private equity funds requires a relatively large minimum investment commitment of between $5M and $10M. Furthermore, if you’d like to diversify your private equity program, you’ll need significantly larger commitment amounts. If you are a smaller investor, private equity investments can be hard to access. But there are ways to diversify private equity programs via fund structures or secondary private equity markets.
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