Private Equity Investing Expands Its Reach

FORECASTS & TRENDS E-LETTER
by Spencer Wright
November 12, 2024

IN THIS ISSUE:

Private Equity Investing Is More Available Than Ever
An Overview of the Private Equity Structure
The Benefits Private Equity Investing
The Risks of Private Equity Investing
Final Thoughts

Historically, private equity investing has been the province of institutions and very high net worth individuals. Today, private equity is more widely available thanks to regulatory adjustments regarding investor suitability, increased transparency of the asset class in general, and the emergence of ‘fintech’ driven alternative investing platforms. These elements combine to bring access to private equity to more investors than ever before.

Private Equity Investing is More Available Than Ever

Let’s examine the last one more closely. These platforms act as an intermediary between investors and private equity opportunities. They generally offer greater transparency and reduced investment minimums for qualifying investors to access private equity funds. Examples of these platforms are CAIS, Nasdaq Private Market and iCapital.

Private equity funds available directly through RIAs are also more accessible than in years past. In many cases minimums are much lower, in some cases less than $25,000, and as mentioned above investor requirements regarding net worth are not as high.

There are even private equity ETFs that invest in indexes of private equity offerings. While these may seem attractive, they are subject to the vagaries of the markets just as any publicly traded security. As you will see this public indexing eliminates one of the greatest benefits of private equity.

An Overview of the Private Equity Structure

Here is an infographic that summarizes the private equity fund structure.

Graphc showing private equity fund structure

Private equity funds are usually organized as partnerships. There is a sponsor, say XYZ Investments. XYZ hires ABC to manage the fund so ABC would be the management company. Instead of publicly traded stocks, the XYZ private equity fund has entire companies in its portfolio, which are known as portfolio companies. Investor capital flows into the fund which then purchases the portfolio companies based on the funds specified criteria. Management fees are paid to ABC and the General Partner (GP) receives the carried interest (a share of the profits of the fund). In some cases, the GP is a separate entity but is usually a member of the management company.

While private equity structures can seem opaque, they are relatively straight forward as illustrated above.

The Benefits of Private Equity Investing

With private equity offerings more accessible you may be wondering about the benefits to private equity investing. Consider this illustration.

Graphic showing potential effect of adding private equity to a diversified portfolio

This graphic illustrates the incremental addition of private equity to a portfolio and the resulting risk/return effect it has. As you can see, risk is lowered while the return is enhanced. How is this achieved? Through greater, real diversification. Most public index and large cap fund investments are highly concentrated in the same mega-cap tech-heavy giants while private equity funds are invested elsewhere.

The public vs. private dynamic is also very important for real diversification. Private equity portfolios are not generally affected by the ups and downs of the public markets. This ‘insulation’ provides stability to a portfolio in turbulent times. These are among the reason private equity has been very popular with institutions and the very wealthy for decades.

The Risks of Private Equity Investing

Of course, investing in private equity carries risk. Private equity funds can be subject to valuation risk in the event a portfolio company is bought for a premium of X and over time is only deemed to be worth a valuation of Y. Such underperforming portfolio company re-valuations can come all at once, dramatically impacting invested value.

There is also the potential for increased default risk as private equity placements can use a large amount of leverage in the form of debt to finance deals. This practice is somewhat less common than it once was, but would-be investors should be aware and ask the necessary questions.

The greatest risk factor investors should keep in mind when considering private equity is liquidity. Unlike their public counterparts, private equity offerings often have restrictions on liquidity. Generally, this means that access to your invested capital is restricted or ‘locked up’. These lock periods can extend for years in some cases and then liquidity may only be offered on a quarterly basis or less. ALWAYS request a liquidity schedule.

Final Thoughts

Private equity funds had been core holdings of institutions and ultra-high net worth individuals for decades but now are accessible to many retail investors. The addition of private equity to your portfolio can have a beneficial impact on the overall risk / return ratio. There are many types of private equity funds, most of which have limited liquidity.

Private equity is an excellent tool that offers true diversification at the portfolio level. These offerings are within reach for many investors. As with all investments, private equity is not right for every investor. Do your due diligence and always ask for a liquidity schedule.

Thanks for reading,