Private Equity – Alternative Investment Series Part 2
Tonight, I’m being lazy. This is my son’s first year of organized basketball (3rd grade) and rather than drop him off, drive home, and drive back 45 minutes later to pick him up, I have decided to test the limits of my noise-canceling headphones by sitting in the gym to finish this blog post. As I marveled at the technology capable of drowning out bouncing basketballs, coaches, and yelling elementary school children, I quickly looked to see if I can invest in Bose stock (this is not a paid endorsement 😊.) Unfortunately, Bose is not a publicly traded company, so my investment dollars will have to go elsewhere…or will they?
In a continuation of our Alternative Investment Series, today’s post is going to focus on a specific type of alternative investment, private equity. If you have not already done so, I encourage you to take a few minutes and watch the introduction video, the “Part One” post discussing “why” alternative investments, then come back to this specific article. I also recommend grabbing a cup of coffee, as this post gets a bit longer than my usual post.
What is Private Equity?
At its simplest, private equity is just investing in a company that is not listed on a public exchange. When someone mentions private equity, the first thing that often comes to mind is “venture capital.” We have all heard the stories about how a few “lucky” investors heard a pitch about some up-and-coming company and invested on the “ground floor,” only to become “rich” when the company went public. While venture capital does fall under the umbrella of private equity, there are many types of private equity, which we will discuss later in this post. Your investing goals and risk appetite will dictate which, if any, private equity investments should be in your portfolio.
Why Private Equity?
Over the past 20 years, the number of public companies in the U.S. has dropped from a peak of around 8,000 U.S. companies listed in the late 1990s to approximately 5,000 today[1]. Some private companies choose to stay private to avoid regulatory concerns, while others find it easier to raise capital in the private sector. Whatever the reason, the issue remains that if investors only invest in the public market, their options, while still vast, have shrunk considerably over the last twenty years. In addition, many companies that are choosing to go public are doing so later, meaning investors are still missing out on potential returns while waiting for companies to go public so they can purchase on the stock exchange.
Types of Private Equity
While there are several categories of private equity, I want to highlight three:
1. Venture Capital – This is the category that many people think of when hearing the term private equity. Essentially, this is when someone invests in a startup, or new, company. Generally speaking, of the major categories of private equity, venture capital has the greatest return potential, but also the greatest risk. Often, investors look for experienced entrepreneurs with a good track record in starting new companies before funding a venture capital investment.
2. Equity Growth – If venture capital is the first phase of a private company’s life cycle, equity growth is essentially the next broad phase of a company’s lifecycle. Equity growth firms may not yet be profitable, but generally have a stable revenue flow and may be looking for more capital to continue their growth.
3. Buyouts – This is the largest type of private equity investing. This is when an investor buys out an established company, either to have a majority interest in the company (and thus control), or they purchase a public company with intentions of turning it back into a private company. While this category may have the lowest return potential compared to the previous two, it is also fair to say that the risk is lower, as these are often established companies with a good track record.
How to Invest in Private Equity?
Access to private equity has changed considerably over the last few years, mainly for the better. Private equity used to be restricted to large institutional investors or individual investors with large amounts to invest. However, new investment structures and legislation have been put in place that allow more investors than ever to access private equity.
1. Direct Investment in Private Equity – Historically, this has been the only way to invest in private equity. Most private equity companies have high minimum investment requirements, such as $10 million or more. In addition, investors need to meet the standards of an “accredited investor,” which is generally defined as an investor with more than $1 million in assets or a minimum household income of $200,000 for single people and $300,000 for a married couple.
2. Closed-End Funds – This type of investment vehicle has greatly expanded access to private equity investments for investors. Closed-end funds have been in existence for a long time but have moved into the private equity area over the last few years. For some closed-end funds, investors still need to meet the accredited investor threshold, but investment minimums are usually much lower, starting at $50,000 or $100,000. However, there are several closed-end funds that you can purchase in your brokerage account that do not carry the accredited investor requirements.
3. Crowdfunding – Yes, the private equity sector has joined the crowdfunding craze. Essentially, this is where anyone can solicit funds from investors by putting together a presentation of their business plan and putting it online through various platforms. As an investor, you can sort through the myriad of options and select a company to invest in, but in my opinion, this is the riskiest form of private equity investing.
Key Things to Remember
Private equity investing presents some unique opportunities but also has some key challenges that need to be managed by investors and their advisors. While the points noted below should not be considered a pros and cons list, they are important things to consider before investing.
1. Illiquid – Investing in private equity, whether directly or through a closed-end fund, comes with liquidity limitations, in other words, these are not like publicly traded stocks that you can buy and sell as you wish. Most funds offer quarterly options to redeem your shares, but that is not guaranteed, and most have a cap on how much they will redeem each quarter. One needs to look no further than the current news cycle regarding one of the largest non-traded REITs (an alternative investment that we will discuss in an upcoming post) to learn about liquidity limitations on these types of investments.
2. Fees – Fees will usually be much higher than a typical ETF. In addition, there are usually “layers” of fees, and it is not unusual for fees to be about 1.5-2.0% (or higher) annually. While that may seem high, keep in mind that these investments are more complex, so they will naturally carry higher fees.
3. Tax Considerations – Depending on how you invest in private equity, investors will either receive a K-1 or a 1099 tax document. The differences in taxation of these two types of income are beyond the scope of this post, but tax preparation fees could be more expensive if you must report K-1 income. In addition, K-1s are not required to be produced until March 15th, so if you typically like to file your taxes as quickly as possible, you may need to change your tax filing strategy. If the fund produces a 1099, things will be more straightforward for tax filing purposes, especially since most other investments produce a 1099. In addition, 1099’s are normally produced by January 31st (some extensions can be granted to the issuer.)
While access to private equity has improved, that does not mean it is for everyone. Like any other investment, you should consult with your financial planner to understand where it could fit in your portfolio and how to manage the unique risks associated with private equity. Now if you’ll excuse me, I need to find a private equity fund that invests in Bose.
[1] The Financial Times, The Incredible Shrinking Stock Market, 26 June 2019
Like this article? Check out our Investing Archives where we provide insights to help you weather changes in the market.
