An Introduction to Private Equity Investing

Private equity is an investment that involves buying equity in privately held companies. These transactions typically occur off-stock exchanges during various stages of a company's life cycle, including pre-IPO fundraising, and may even involve taking public companies private.

Key players in private equity include insurance companies, pension funds, endowment funds, private equity firms, and hedge funds. To invest in these funds, individuals must meet the SEC's criteria for accredited investors, which generally requires an income of over $200,000 for the past two years or a net worth of over $1,000,000.

Private equity investments are often illiquid and typically require significant initial investments, ranging from $25,000 to $250,000. Investors also face high fees, with fund managers receiving 10-20% of gains as a performance incentive, in addition to an expense ratio of 1-2%.

A New Owner Takes Over

Once a private equity fund has pooled enough assets together from its various accredited individual or qualified institutional investors, it can purchase ownership stakes in multiple private companies or take a public company private. In the case of the former example, existing private companies that receive these cash infusions often relinquish partial or complete control by selling ownership stakes. In return, recipient companies can use the funding to grow, scale, cash out founders, restructure the business, or all of the prior, depending on the deal. 

If the target firm fails and goes bankrupt, the private equity fund writes off the investment and attempts to recoup its losses by liquidating the business or its ownership stake. 

Concurrently, suppose the target firm becomes more profitable and desirable. In that case, the private equity fund can distribute a portion of its profits to fund investors, generating a steady income if the business stays private or a one-time payment if it goes public or is sold.

While these scenarios highlight the value private equity can bring, critics argue that their "strip-and-flip" business model can harm companies and communities. This approach involves acquiring companies to eliminate unproductive units and reduce costs, often resulting in layoffs, the sale of legacy divisions, and restructuring efforts aimed at boosting profitability.

Many people consider private equity firms to be predatory, due to the history of some firms harming local communities at the expense of temporary shareholder returns. These views are valid, and while they do not reflect the activities of all private equity firms, they are valid critiques of the industry.

Studies by Harvard, the Census Bureau, and the Universities of Maryland and Michigan found a 1% net decrease in jobs at target firms after two years, despite notable increases in earnings per share and productivity, which some argue represent a net social gain.

While we will not delve further into the complex social implications of private equity buyouts, it's crucial to recognize that such deals can create both winners and losers. Therefore, the need for competent regulators is essential, and it is the person investing money in these firms that needs to decide whether or not social implications are a consideration for themselves when investing.

Common Today, Changes Tomorrow

The private equity sector has primarily served institutional and ultra-high-net-worth investors, but it has expanded to include accredited investors with less wealth over the past few years. Additionally, as of yesterday, the current President of the United States just ordered a review of what investments fiduciaries may offer 401(k) investors to open up access these markets with fewer regulations. Still, fees have remained high, and overall, there is a lack of competition due to the control of many large firms over this market. Whether increased demand will create new challengers and yield better overall returns for investors remains to be seen.

Investment Drawbacks

Private equity investing has several drawbacks compared to traditional public equity investing through mutual funds, ETFs, and stocks. Key issues include a lack of liquidity, high minimum investments, substantial fees, and limited transparency.

With private equity investments, investors often face difficulties in selling ownership stakes, as these transactions typically occur off-exchange. Furthermore, they must comply with the offering firm's cash redemption schedule, which is normally limited to quarterly options, or find secondary market buyers, which can be costly and involve significant uncertainty.

Similarly, private equity firms have fewer regulatory reporting requirements, resulting in less transparency for accredited and institutional investors. This makes it more challenging to verify the information provided and increases the risk to investors.

Finally, because all private equity funds are actively managed, returns are heavily influenced by the decisions of the fund manager chosen. Selecting the wrong manager or fund type can significantly impact returns, making such investments less attractive to many investors.

Benefits of Private Equity Investments

Private equity presents unique benefits, despite its opaque risks and drawbacks, notably providing investors with access to a segment of the economy that is often unavailable. In 2022, approximately 21,000 U.S. companies generated revenues exceeding $100 million, with private entities outnumbering public ones by more than six to one, comprising nearly 87% of the market, according to Hamilton Lane.

Therefore, investing in private equity allows for greater portfolio diversification beyond a limited pool of public companies. Historically, from 1990 to 2020, private equity outperformed the global public equity market. However, past performance is not indicative of future results, and Hamilton Lane's data may be biased due to its interests.

Research indicates that an illiquidity premium exists in private equity, where investors often receive higher returns due to the risks associated with investing in less liquid assets. This dynamic means investors can pay lower prices for stakes in companies that face higher failure risks but reap greater rewards if they succeed. Nevertheless, as competition has increased, returns have diminished.

Private market funds also have a lower correlation with U.S. and international stock indices but are more challenging to value. For ordinary investors seeking private market exposure who do not meet the criteria for accredited investors, fund-of-funds mutual funds and ETFs are available. Additionally, future access through 401(k) plans may soon become commonplace if the current President follows through on his recent statements. However, these investment vehicles come with limitations, including higher fees and limited control over investment choices due to pre-bundled structures. So, proceed with caution.

Closing Thoughts

Private equity funds are increasingly marketed as an exciting investment option for advisors and accredited clients. However, while they offer benefits, they also come with significant risks that are hard to quantify and restrictions that make them less appealing than publicly traded investments.

As it stands, private equity is generally unsuitable for most investors, especially those seeking easy access to the value of their portfolio and transparency. Additionally, high fees and the lack of indexing make it less attractive for those who prefer indexing as a wealth-building strategy. Still, we acknowledge that private equity can offer a worthwhile value proposition for certain types of investors.

If you meet the accredited investor requirements and are unsure whether to consider adding private equity to your investment portfolio, we are here to help. We have strong, firm values and compliance rules in place that help us ensure we match our investors with suitable investments. We are here to help you determine which portfolio options are worthwhile for you. When you are ready for this conversation, please reach out to us to schedule a consultation, and we will look forward to talking with you then.