Building and Protecting Wealth with Private Equity: A Client Story
Many investors share similar goals regarding investing, building wealth, and planning for the future. These goals often include maximizing contributions to retirement accounts such as IRAs and 401(k)s, investing surplus funds in taxable brokerage accounts, and exploring other tax-advantaged options like a Health Savings Account (HSA) to build a diversified portfolio.
There's nothing wrong with striving for these "common" goals; in fact, they often form the backbone of your financial success by fostering healthy habits like consistency, discipline, and risk management.
But while these popular accounts might be excellent options for saving and investing towards a secure future, they have limitations in the types of investments they can hold, usually restricted to stocks, bonds, mutual funds, and exchange-traded funds (ETFs).
And sometimes, investors reach a point where they've checked all the boxes and wonder, "What's next?"
That's exactly where one of our clients — a now successfully and happily retired Baby Boomer — once found himself. His "next" endeavor? Investing in private equity.
I recently caught up with him over coffee at a local café in his upscale Chicago suburb on a beautiful, sunny day. It took him a while to locate a parking spot for his Porsche 911 among the many other seemingly successful professionals out and about relishing the rewards of their hard work.
I prompted him to reflect on his decisions to partially fund his retirement with private equity, hoping to provide others (like you) with a fresh perspective beyond the conventional options to live your life by design and not default — an opportunity that has shaped his success.
But before we dive into what he had to say, let's first establish what private equity is and why it might be worth considering if you, too, are contemplating "What's next?"
Breaking It Down: What Is Private Equity?
Private equity involves owning or having a stake in an entity that isn't publicly listed or traded. That means the average investor can't simply log into their 401(k) or taxable brokerage account and buy ownership shares, as they could with a publicly traded company like Amazon.
Beyond that, private equity investments are typically restricted to accredited investors, adding another barrier to entry for potential investors.
The Details: Private Placement Memorandum (PPM)
Before committing to any investment, it's essential to fully understand what you're getting into. When considering private equity investments, these specific details are typically outlined in a private placement memorandum (PPM) document.
Broadly speaking, the PPM encompasses essential details such as the investment strategy, objective, terms and conditions of the offering, expected returns, fees and expenses, risks involved, and the rights and responsibilities of investors.
More specifically, the PPM might cover details such as:
The type of company you're investing (i.e., an early start-up or a distressed company)
Minimum investment amounts
Lock-up periods (periods during which investors can't withdraw their funds)
Legal structure, including the roles and responsibilities of partners and any advisory board or committee
Distribution waterfall (how profits are allocated among general and limited partners)
As a side note, our client prefers investing at the general partner level, where the distribution waterfall is, in theory, more lucrative. General partners typically have more responsibilities and carry greater liability than limited partners, who usually take on a more passive role. But as the saying goes, the greater the risk, the bigger the reward!
As you might expect, a private placement memorandum is essential for understanding and evaluating private equity investments, guiding investors to make informed decisions.
Tax-Sheltering Strategies: Keep More of Your Money
Beyond further diversifying their investments and seeking higher potential returns, another significant benefit for investors venturing into private equity is the potential to reduce or defer tax liabilities. Here are some common tax-sheltering strategies used in private equity:
Capital Gains Treatment: Profits from investments held longer than one year are usually taxed at lower capital gains rates, which can be beneficial compared to higher ordinary income tax rates. Additionally, carried interest, which is income that flows to a general partner based on performance, also receives preferential capital gains tax treatment.
Pass-Through Entity Structure: Many private equity opportunities are structured as pass-through entities like limited partnerships or limited liability companies (LLCs). Income and gains by these entities flow through to investors, who report them on their individual tax returns. This creates some flexibility in tax planning and offers potential business deductions and credits that can help offset other sources of income.
Tax Loss Harvesting: Private equity investments can experience losses in some years like any other investment. These losses can be used to offset capital gains from other investments or income, which helps in reducing overall taxable income.
Tax Deferral: Some private equity investments offer tax deferral benefits, allowing taxes on gains to be deferred until investors sell their interest or receive distributions.
Additionally, investing in private equity through a retirement account, like a self-directed IRA, allows for tax-deferred growth within the account. In this case, taxes are deferred until distributions are taken in retirement, potentially maximizing the compounding of investment returns over time.
While there are many attractive benefits to investing in private equity, ranging from diversification to powerful tax sheltering strategies, it's important to recognize the risks and potential downsides.
Taking Calculated Risks with Private Equity
As with any investment, private equity involves risks, including periods of illiquidity and the possibility of capital loss. As our client reflected on his journey as an investor, he recalled the calculated risks he took when he decided to use his retirement funds as start-up funding for his private equity venture within a self-directed IRA. He remained undeterred despite the volatile market conditions before and after the 2008 financial crisis.
Why did he do it? Had he followed the crowd, he would've settled for average returns.
Taking control of his income coincides with his entrepreneurial spirit, and he's always scouting for niche opportunities in the market. When one sector is experiencing a downturn, he strategically seeks new opportunities. For example, during a decline in commercial lending, he sees an opportunity for the emergence of private funding.
He firmly believes that every downturn creates a corresponding opportunity for growth. Another prime example he shared? Real estate investors who dared to invest right after the 2008-2012 mortgage crisis, many of whose portfolios, today, are nothing short of impressive.
For him, it's a risk that has been well worth taking. He has allocated a substantial amount to private equity in his self-directed IRA, which we help him manage. What influenced his decision? For him, it served two key purposes: accelerating portfolio growth and taking advantage of tax sheltering opportunities.
As a principal partner in a private company, it was about backing his beliefs with action and putting his money where his mouth is.
Is Investing in Private Equity Your 'Next' Level? We Can Help Get You Started
Investing in private equity requires a different level and type of due diligence than investing in publicly traded stocks. It involves comprehensive analysis, often with the support of legal and industry experts, to carefully assess the landscape before committing capital. It's a rigorous but necessary process to minimize risks and maximize your potential for success.
At Chicago Trust Administration Services, we pride ourselves on our expertise in helping clients invest in private equity opportunities within a self-directed IRA. This is a specialized area that even accountants and attorneys often need more familiarity with (just ask our client about that one!).
If you're at a point where you're contemplating "what's next?" we'd be delighted to chat with you about your goals and explore whether investing in private equity could be a suitable option for you. To see how we can help, we invite you to schedule a complimentary meeting with us by calling 312-869-9394 or emailing steve@ctasira.com.
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*The content and opinions in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
**CTAS professionals are not financial advisors and cannot provide advice or recommendations regarding specific investment decisions.