How You Can Leverage Private Equity for Portfolio Growth
Have you ever wondered why the rich keep getting richer, typically? Along with many social and financial advantages, exceptionally wealthy people can access opportunities that others can't. Private equity (PE) is a lucrative investment vehicle usually requiring a financial passkey to participate.
Although technology and lawmakers are making PE more accessible to retail investors, private equity primarily remains an investment vehicle for wealthy and sophisticated investors.
However, you can explore new pathways to private equity or use its principles to grow your portfolio. This article provides vital information about PE to help you determine whether it is a good investment option.
What is private equity investing?
Private equity investing involves acquiring, managing, and eventually selling equity ownership in privately held companies. Private equity firms typically raise capital from institutional investors, high-net-worth individuals, and pension funds to form investment funds. These funds are then used to acquire stakes in privately held companies, often to implement strategic initiatives to promote growth and improve operational efficiency.
Private equity investors assume an active role in managing their portfolio companies, working closely with management teams to implement changes, make strategic decisions, and ultimately enhance the value of the businesses. The investment horizon in private equity tends to be longer-term than public market investments, allowing investors to execute value-creation strategies over several years before seeking exits through initial public offerings (IPOs), mergers and acquisitions (M&A), or secondary sales.
Private equity investing offers attractive potential returns. However, it also involves risks such as illiquidity, market volatility, and operational challenges, requiring careful due diligence and expertise from investors and fund managers alike. Private equity generation involves three groups.
Why does private equity yield higher returns?
Investors often make more money in private equity compared to other investment options due to several factors:
Access to Unique Opportunities
Private equity investments provide access to diverse investment opportunities that may not be available in public markets. These opportunities include early-stage companies, distressed assets, and private companies with growth potential.
Active Management and Operational Improvement
Private equity firms typically actively manage their investments. They work closely with portfolio companies to improve operations, enhance efficiency, and drive growth strategies. This hands-on approach can lead to significant value creation over time.
Long-Term Investment Horizon
Private equity investments often have a longer time horizon than public market investments. This longer-term perspective allows investors and fund managers to implement strategic initiatives and patiently wait for investments to mature, potentially leading to higher returns.
Potential for Higher Returns
Private equity investments have the potential to deliver higher returns compared to public market investments. Scholars often attribute this quality to the illiquidity premium associated with private investments and the ability of private equity firms to capitalize on market inefficiencies and actively create value in their portfolio companies.
Alignment of Interests
In private equity, fund managers typically invest a significant portion of their capital alongside their limited partners. This alignment of interests ensures that fund managers are motivated to generate solid returns for investors, as their wealth depends on the fund's performance.
Control and Influence
Private equity investors often have greater control and influence over portfolio companies' management and strategic direction. This control allows investors to implement changes and make decisions that can positively impact the value of their investments.
Diversification Benefits
Private equity investments can produce diversification benefits to an investment portfolio. They are often negatively correlated with stocks, bonds, and other traditional assets. This characteristic can help mitigate overall portfolio risk.
How much of an earning advantage can private equity give an investor?
Suppose we have $1 million to invest. Using a 10-year average annual return calculation, we can compare the total 10-year returns of private equity, public stock, and mutual fund investments.
Private equity
According to Cambridge Associates' US Private Equity Index, private equity yielded an average annual return of 14.65% over 20 years ending June 2020. So, suppose we have $1 million to invest in PE. Using the compound interest formula, our 20-year return would be approximately $60,202,935.60.
Public stocks
The same source revealed that the S&P 500 had an average annual return of 5.91%. Using this figure with the same formula, our $1 million investment in the S&P would yield $3,886,964.81 for 20 years.
Mutual Funds
The 2024 Gitnux Marketdata Report stated that the average mutual fund return was 4.25% over 20 years ending in 2019. This arrangement would give us $2,200,623.21 over 20 years.
How do PE performance and returns differ from other investments?
Private equity investors are known for their long-term investment horizon. Typically comprising high-net-worth individuals and institutional investors, they establish funds to acquire either a public company and privatize it or take control of an established private company, preparing it for an initial public offering (IPO).
This process is not swift—it often spans a decade or more, encompassing the time required to identify a suitable company for acquisition and then restructure it to enhance its operations. Ultimately, when a private equity fund exits its investment, it typically does so by either selling the company to a corporate buyer or initiating an IPO.
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A defining feature of private equity investing is the extended duration until realizing returns. Investors essentially trade liquidity, or immediate access to cash, for the potential of achieving higher returns over time. Consequently, private equity investing primarily appeals to investors who possess substantial financial resources and can commit these funds for an extended period.
Understanding the returns
Private equity firms and seasoned investors evaluate performance using various valuation metrics, including Internal Rate of Return (IRR), Multiple of Invested Capital (MOIC), and Public Market Equivalent (PME). Among these, IRR is particularly pivotal, representing the expected growth rate of an investment over time. It differs from the conventional annualized return on investment by considering the timing of cash flows and assuming reinvestment of distributions. On the other hand, MOIC offers insights into the total return of an investment, disregarding the rate of return or the time frame for the return. PME, meanwhile, enables a comparison of a private equity fund's investment performance with equivalent investments in public financial markets.
How to qualify for investing in private equity?
Investing in most private equity opportunities requires meeting specific qualifications due to the unique characteristics and risks associated with these investments. While specific requirements may differ by jurisdiction and the private equity fund itself, investors generally need to meet the following criteria:
Accredited Investor Status
In many jurisdictions, including the United States, investors must meet accredited investor criteria to invest in private equity funds. Accredited investors have a high net worth or income, as defined by securities regulations. For example, in the US, an accredited investor earns an annual income exceeding $200,000 ($300,000 for married couples) for the past two years or a net worth of over $1 million, with the value of their primary residence.
Sophistication and Experience
Private equity investments are complex and may involve substantial risks, including illiquidity and capital loss. They require investors with exceptional financial sophistication and experience in evaluating and managing investment risks. Some private equity funds may require investors to demonstrate prior experience in investing in similar asset classes or industries.
Minimum Investment Requirements
Private equity funds typically have minimum investment requirements, varying widely depending on the fund's size, strategy, and target investors. These minimum investment thresholds can range from tens of thousands to millions of dollars. You must be able to commit the required capital for the entire investment period, which can span several years.
Suitability and Risk Tolerance
Private equity investments are unsuitable for all investors and may not align with everyone's risk tolerance and investment objectives. You should carefully examine their financial situation, investment goals, and risk tolerance before allocating capital to private equity. Due to the illiquid nature of private equity investments, you should also expect to hold their investments for an extended period without needing to access their capital.
Access and Relationships
In some cases, private equity investment access is exclusively available to individuals with pre-existing relationships or connections with private equity firms or investment professionals. These relationships can provide exposure to exclusive investment opportunities and insights into the private equity market.
Will Private Equity ever be available to retail investors?
There are indications that lower net-worth investors may have increasing opportunities to participate in private equity investing. However, the extent of their access can vary based on regulatory changes, technological advancements, and evolving market trends. Here are some factors contributing to the potential expansion of private equity access for lower net-worth investors:
Regulatory Changes
Regulatory bodies in some jurisdictions are considering or implementing changes to allow broader access to private equity investments for retail investors. As an example, the US Securities and Exchange Commission (SEC) has proposed amendments to accredited investor criteria, which could expand the pool of eligible investors to include those with specific professional certifications, designations, or credentials indicating financial sophistication.
Technology and Platforms
Technological advancements and the rise of online investment platforms offer investors private equity opportunities. Some crowdfunding platforms and online investment marketplaces provide access to private equity investments with lower minimum investment requirements, allowing retail investors to participate alongside institutional investors.
Private Equity Funds Targeting Retail Investors
Some private equity firms are launching funds designed to cater to retail investors, offering lower minimum investment thresholds and simplified investment structures. These funds may target specific sectors or investment strategies and provide retail investors with diversified private equity portfolios.
Secondary Markets and Fund Structures
Secondary markets for private equity interests and the emergence of alternative fund structures, such as interval and closed-end funds, can provide retail investors with opportunities to invest in private equity indirectly. These vehicles allow investors to access private equity exposure through publicly traded securities or periodic liquidity events.
Education and Awareness
Increasing awareness and education about private equity investing among retail investors can help demystify the asset class and facilitate greater participation. Financial institutions, investment advisors, and industry associations may offer educational resources and guidance to help investors understand private equity investments' risks, benefits, and considerations.
Final note
Many private equity investments require too much capital and expertise for most of us to participate. However, there are low-entry avenues we retail investors can use to share in the returns of private equity earnings.
In addition, now that you understand the principles and methodology of PE investing, you could form a scaled-down version of a private equity group to invest in smaller projects using the same principles.
I once had a co-worker who joined a group of friends to own and manage the career of a pedigreed racehorse. Some members of the group were horse racing experts. So, they managed the horse's training, upkeep, and racing. After several years, the horse eventually won a significant derby, and all the investors got a handsome share of the prize money and a share of the ultra-lucrative stud fees.
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