What Are Private Equity Investments? An Asset to Diversify Your Retirement Strategy
There are very few secrets to the traditional investment assets available in public markets. Savvy investors and rookie investors alike know how to utilize stocks, bonds, and cash to grow their retirement portfolios. What is more unfamiliar to many is an alternative asset known as private equity (PE).
Alternative assets are named as such because they are not accessible via “conventional” retirement investment vehicles like traditional and Roth IRAs. Besides PE, other alternative assets would be things like collectibles, commodities, futures, derivatives, hedge funds, and real estate.
Alternative assets are attractive to investors because they serve as a counterweight to traditional assets. When crises like war and inflation loom, standard asset classes often lose their value. However, alternative assets usually have a negative correlation with the stock and bond market. This makes them a valuable tool when looking to diversify your portfolio.
Private equity in particular has a reputation for offering great potential returns. According to reports, PE has offered an annual average return of 15% since 2009. What’s more, if you just consider buyouts (a subset of private equity), average returns have been 5% better than those seen in public markets over the course of the last 30 years (13.1% vs. 8.1%, respectively).
Given the upsides, it is certainly worth asking: what are private equity investments, how do they generate income, and what can you do to make them a part of your retirement portfolio?
What Are Private Equity Investments?
In the simplest terms, private equity is ownership in a company that is not publicly traded. Private equity allows investors to gain control or interest in private companies they would otherwise not be able to invest in.
Though PE has become more available to the everyday investor, many private equity firms will only allow accredited investors to invest in the assets they manage. To be an accredited investor you must meet at least one of a number of requirements regarding income, net worth, or professional experience. This reserves many PE options only for those considered high-net-worth individuals.
When you invest in private equity you are essentially supplying capital to a PE firm. That private equity firm will pool your money, along with money they’ve collected from other investors, and use it to buy an ownership share of a private company. The company will become a part of the firm’s portfolio. It may now be referred to as a portfolio company.
How Do Private Equity Investments Make Money?
In some cases, PE firms inject fresh capital into a portfolio company to give them enough cash to get their great ideas off the ground. In other cases, a PE firm will install new leadership, technology, or operational processes to rejuvenate a company that has had too many obstacles on their path to success.
To be successful, private equity firms must be shrewd business and investment managers. Their ability to obtain high rates of returns rests mainly on two things. First, they must be able to identify and acquire companies who have significant potential value. Second, they must be able to successfully guide companies through rapid performance improvement.
Regardless of how involved a PE firm gets in the day to day of their portfolio companies, the goal is to make quick improvements so they can turn around and sell them for a hefty profit.
With PE, the key to large returns is the buy to sell strategy private equity firms employ.
Public firms typically acquire other companies for the sake of integrating them into their overall, long-term strategy. When initially purchased, an acquired company’s value usually soars, due to the expected benefits of becoming part of the acquiring company’s portfolio of brands. Over time however, the value of the acquired company will flatten out.
When private equity firms acquire a company their purpose is to quickly improve performance and then sell the company for a substantial profit. The PE firm sells its portfolio companies when their value is highest, avoiding the later years when value would decrease.
What to Know About Private Equity as an Income-Producing Asset
In most cases, it is primarily the opportunity to “cash out” shares for profit when a portfolio company is sold which provides the most value to a private equity investor.
Similar to stocks and bonds however, there are private equity investments you can make which pay dividends at regular intervals. There are also private equity investments you can make which will not.
Whether or not your PE fund pays dividends will depend on how the managing firm contracted terms with acquired companies. If a private company is asked to pay dividends to its investors it is often the case they will have to take on increased debt to do it, which can be a risk to the company’s overall success.
Risks of Private Equity Investment
There are risks associated with private equity, just as there are with any investment. Before you decide to invest you should always weigh the costs and determine what level of risk you are willing to assume.
Common risks traditionally associated with private equity are:
Lack of transparency / oversight
Illiquidity
Conflicts of interest
Management and performance fees
In terms of oversight and transparency, PE funds are not required to be registered with the SEC. Because of this, these funds are not required to provide regular disclosure statements. Of course PE firms will still have a vested interest in turning a profit, but they do not always provide the same level of transparency investors may be familiar with.
Illiquidity can also be a concern for those investing in private equity because of the long term time horizon associated with acquisitions and company turnarounds. Assets under private equity management may not be sold for five or more years.
While advisers within a PE firm must disclose all conflicts of interest between themselves and the funds they manage, conflicts may still exist. It is important to know what these conflicts are and make your investment decisions accordingly.
Lastly, the fee structure of a PE fund should be a consideration for any investor. Make sure you are able to stomach any required fees associated with your private equity investments. These could include performance fees or fees for managing the fund.
It is never a guarantee that the capital supplied through private equity investments will result in a company’s success. However, private equity investments exist for a reason. They often turn around lofty rates of return and can offer a healthy amount of diversification for an investor’s retirement portfolio.
Invest In Private Equity With The Help of Chicago Trust Administration Services
Traditional IRAs won’t allow you to invest in private equity. However, a self-directed IRA (SD-IRA) is a popular option for many investors because it opens the door to alternative assets like PE. When you pair the potential returns and diversification benefits of private equity with the tax benefits of an IRA it can go a long way in setting you up for financial security in retirement.
At Chicago Trust Administration Services, we have spent the last two decades assisting high-net-worth individuals self-direct their futures. We are SD-IRA custodians who provide IRS-compliant services to help you make transactions that will reliably grow your portfolio.
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.