What Should I Know About Private Equity Investing?
Private equity is an investment class that allows individuals to invest in assets outside the public market. Investors gain ownership in private companies to diversify their portfolios and increase their chances of high returns. Because private equity investments may present opportunities for higher returns than publicly traded companies, they are also traditionally riskier than other types of investments.
In the last few years, private equity has been the preferred choice of accredited investors. It is “niche” investing and offers diverse focus options, including corporate acquisitions, start-up capitalization, debt financing, real estate value-add projects, and much more.
Who Can Invest in Private Equity?
Not just anyone can invest in private equity. Only accredited investors and institutional investment firms can invest in private equity. To be accredited, individual investors need to meet or exceed a net worth of $1,000,000 or an annual income limit of $200,000 ($300,000 for joint earners). In August 2020, the SEC expanded its definition of accredited investors to include individuals who meet specific defined measures regarding professional knowledge, experience, or certifications.
The SEC has determined these regulations to protect less knowledgeable and experienced investors who may not be able to absorb financial losses. Because private equity investing is inherently risky and typically demands high minimum entries, it’s important that only well-equipped individuals who can sustain significant financial losses invest in private equity.
Benefits of Private Equity Investing
As stated above, private equity offers investors innovative opportunities to improve risk and reward characteristics of their portfolio and increase higher returns overall. Comparing private equity returns to publicly traded index funds is notoriously difficult, and there is some controversy over whether private equity really does outpace public equity returns.
However, some studies show that in the 20 years between 2000 and 2020, private equity showed 10.48% returns, while the S&P 500 showed only 5.91% returns in the same period. Nonetheless, it is important to understand that valuation metrics used to determine private equity returns are different than valuation metrics used to determine returns on publicly traded companies, hence the difficulties in making concrete comparisons.
Beyond the opportunity to diversify and earn higher returns, private equity offers other attractive prospects to investors. Some private equity investors prefer to target existing companies with room for improvement. If a company is being mismanaged, private equity investors may identify opportunities to get the company back on track, later selling it at a profit. These types of deals can result in high profit margins.
Private equity deals also give investors a more controlling interest in the companies they invest in. When investing in venture capital start-ups, many private equity investors gain a majority role in management decisions. For experienced investors, this can be a great opportunity to use their skills and make a company more profitable. Additionally, the private equity market gives investors access to the stimulating world of innovative entrepreneurs who are poised to shape the future.
Drawbacks of Private Equity Investing
Of course, hardly anything comes easy in life. Beyond the inherent risk in investing in young start-up companies or mismanaged mature companies (as an example), private equity has other downsides as well. For one, private equity opportunities may not be good options for investors who lack the expertise or experience needed to effectively manage a company and grow its profits.
Private equity investments are also often accompanied by long-term investment horizons, sometimes for 10 years or more. Capital calls for private equity investments often begin around $250,000, and indeed, some high-end private equity firms only accept investors who can put up $25,000,000. Because private equity investments are so illiquid, not being able to access this amount of cash can sometimes outweigh the risk for many investors.
For this reason, many accredited investors prefer to invest in private equity through their self-directed IRA or other retirement plan, knowing they won’t be accessing the funds for years or decades. But self-directed IRAs are heavily regulated by the IRS. Overlooking – intentionally or otherwise – IRS rules can ultimately damage your bottom line and end up costing you more than your initial investment.
Additionally, this “niche” investing comes with the downside of limited investment projects. Private equity companies that have a demonstrated expertise and high capital returns are usually oversubscribed, which means they’re not well-positioned to move on unique opportunities when they arise. Speed of execution to meet capital calls is pivotal because once the funding need is fulfilled, the subscription is closed until the next opportunity.
How You Can Start Investing In Private Equity
But for many investors, these downsides don’t outweigh the benefits of private equity. At Chicago Trust Administration Services, we believe that private equity investments are still obtainable with the right expertise on your side.
Many self-directed administrators are uncomfortable and/or unfamiliar with private equity investing. Some administrators will take over 30 days to review investment documentation before they will determine if they will open an account for you. At this point, the capital call will likely have closed and you’ll be out of luck.
At Chicago Trust Administration, our team funds private equity investments within 48 hours of receipt of subscription and prospectus documents. Of course, the type of retirement plan, the type of investment, and the complexity of the investment structure will all be factors in determining the most effective plan for your private equity investment.