When most people think of investing, they think of the stock market — buying and selling portions of publicly traded companies, subject to the whims of the market and occasional, wild fluctuations.
But there’s a whole other side to the world of investing — private equity. Private equity investments have shown substantial returns in the past, but they come with noteworthy risks that need to be considered. Is private equity investing right for you?
A Crash Course in Private Equity
Private equity is considered an “alternative investment” — something other than stocks, bonds, and cash. Alternative investments tend to be unregulated by the SEC and more illiquid than more traditional forms of investing.
Investing in private equity generally means buying into funds along with other investors known as “limited partners.” Those funds are then used to buy a stake in private companies or engage in buyouts of public companies, taking them off of the public stock exchanges. The capital can be used for anything from research to acquisitions to bolstering a faltering balance sheet.
The Pros and Cons of Private Equity Investing
Private equity investing is a very different animal to stock market investing. Here are some things to consider.
- Negotiating power — when you invest in the stock market, the price you pay is set by the invisible hand of the market. You have no control over the price when buying or selling. With private equity, everything is negotiable. You can talk to your fund manager about lower fees or a reduced minimum commitment if you want.
- Choosing your manager — some managers generate returns by making significant improvements to the companies in their portfolio. Some lean on leverage, which carries higher risks and higher rewards. When you invest, you have the opportunity to dig deep into a given manager’s strategy and choose the one you trust.
- Illiquidity — private equity funds are usually a limited partnership, often with a lifespan measured in years or decades. If you can’t afford to have your funds tied up for 10 years of more, private equity might not be for you.
- Barrier to entry — you can buy stocks for a penny if you want, but private equity firms come with a minimum investment hundreds of thousands to tens of millions of dollars. If you don’t have these funds to spare, private equity investing might be out of reach.
Pay Attention to Fees
Private equity funds come with fees — typically a low management fee and a “carried interest” fee of around 20 percent. That carried interest is the cut of the profits that the manager takes before the remaining profits are shared between investors, and it’s how managers make their money. Before you invest, make sure that the fees are clearly spelled out and that the fund provides audited financial statements that tell you exactly where your money is going.
Talk to the Experts
Private equity investing is much more complicated than this brief article can convey. There are funds of funds, which hold shares in many other private equity funds. There are private equity ETFs, which track indexes of publicly traded companies that are investing in private equities. There are special purpose acquisition companies, which invest in as few as a single private company.
The bottom line is that private equity investing can be risky, and it isn’t for everyone. General recommendations are that you put no more than 10 to 20 percent of your portfolio into private equity funds, but that number will depend greatly on your tolerance for risk, and liquidity needs.
At First Western Trust Bank, we pride ourselves on our ability to create a custom-tailored plan for each individual client. We’ll examine every aspect of your finances, goals, values, and priorities to create a plan that’s right for you. Ready to get started? Get in touch today.
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