Private equity is a way to invest in private companies outside of the public stock market. Private equity investing gives investors an ownership stake in private companies. There are three parties involved in private equity: the investors who provide the capital, the private equity firm that manages and invests the money via a private equity fund, and the companies the private equity firm invests in.
Your money is pooled with the funds of fellow investors and invested in different private equity instruments like venture capital and buyouts. The objective is to generate a return on the investment when the private equity firm sells the company it purchased. Generally, the firm keeps about 20% of the profit, and the remainder is split between the investors based on how much they contributed to the fund.
Potential Pros of Private Equity Investing
Private equity funds have the potential for higher returns than the S&P 500 index. Since 2009, private equity funds have given investors between 1 and 5% more in annualized returns over the S&P 500.¹
In addition, investors in private equity funds are considered limited partners. As such, they have limited liability; the maximum they can lose is the amount they have invested in the fund.
Potential Cons of Private Equity Investing
One potential hindrance to investing in private equity is you must be an accredited investor to invest in private equity funds, and the minimums are steep, typically ranging from $100,000 up to $25 million.
Private equity investments are also illiquid. To see a potential return, an investor needs to hold the fund long-term, often as long as ten years. For investors who may need access to funds more easily, this may not be the best solution.
Private equity funds are not registered with the SEC (Securities and Exchange Commission), so private equity firms are not required to disclose information about their funds publicly. Similarly, privately held companies, which are often what private equity funds acquire, aren’t subject to public scrutiny. It’s up to the fund managers to research these firms. In the case of older companies, there are years of data that may be made available to the managers, but that’s not the case for young start-ups. This lack of transparency and, in some cases, lack of data can make private equity investing risky.
Ways to Invest in Private Equity
To directly invest in private equity, you must work with a private equity firm. Each has its own minimum investment, area of specialization, fundraising schedule, and exit strategy, so it’s essential to do the research to find the best fit for your investing goals. Some of the biggest firms include:
- CVC Capital Partners
- The Carlyle Group
- Vista Equity Partners
Another avenue for investing in private equity is through products offered by online brokerages, such as Fidelity. To invest in these products, you do not have to be an accredited investor, and the minimums are much lower than those of private equity firms.
Private Equity and Modern Portfolio Theory
If further diversifying your portfolio is your goal, private equity is one way to do it. For those who are not accredited investors or don’t wish to tie up large amounts of cash for the long-term, private equity products may be an alternative to consider.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk. Alternative investments, such as Private Equity, may increase risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are subject to the same regulatory requirements as mutual funds, often charge higher fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager. The performance of alternative investments can be volatile. There is often no secondary market for an investor’s interest in alternative investments and none is expected to develop. There may be restrictions on transferring interests in any alternative investment. Alternative investment products often execute a substantial portion of their trades on non-US exchanges. Investing in foreign markets may entail risks that differ from those associated with investments in the US markets. All investments have an inherent level of risk. The value of your investment will fluctuate with the value of the underlying investments. You could receive back less than you initially invested and there is no guarantee that you will receive any income. ¹Past performance is not a guarantee of future results. The Standard & Poor's 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock's weight in the index proportionate to its market value. You cannot invest directly into an index.