When it comes to investing, your options are not limited to equities, bonds, and money market instruments alone.
There are many non-traditional, alternative investments that can help you diversify your portfolio and give you excellent returns in the long term. One such alternative investment is private equity.
Many of the world’s most respected investors, such as Ivy League endowments, big pension funds and money managers for the rich, use private equity to get extra returns not available to ordinary stock and bond investors.
Here’s how it works.
What is private equity?
Private equity refers to the investments made by private individuals and institutional investors in private firms. In some cases, private equity investments are also made in public companies to take them private, that is, to get them delisted from the public stock exchanges.
Private equity investors generally exercise a great deal of control over the company they invest in. They also tend to take measures to increase operational efficiency and to make the company more profitable. These include:
- Restructuring the company
- Implementing cost-cutting measures
- Bringing in a new management team
- Adopting new technologies
Private equity investors tend to invest in different types of companies at different stages of their development. The most common types of investments include the following:
Venture capital involves investing in start-ups which show great growth potential as well as early-stage businesses. It is a risky endeavor; growth forecasts could prove to be false in the future, in which case you could lost most of your investment.
On the other hand, if the company meets or exceeds the projected growth rate, you can get tremendous returns on your investment.
Growth capital involves investing in companies which have a proven track record and are in need of funds to restructure or expand their operations.
This approach involves buying out an entire company or a division of a large company. Once you acquire full ownership of the company you can make as many changes as needed — from restructuring the organization to bringing in new talent — to make it profitable.
Restructuring involves investing in distressed companies with the intention of turning them around which impresses more people than asking for a tax payer bailout.
Why private equity?
There are several advantages to investing in private equity.
Investing in private equity can help build a truly diversified investment portfolio. Unlike traditional investments, such stocks and bonds, the returns on a private equity investment are not tied on the performance of the stock market. By investing in alternative investments such as private equity you can lower risk in your portfolio.
The returns on private equity investments can be substantial in the long term. A study conducted by the Boston Consulting Group in 2012 revealed that half of the companies which receive private equity funding managed to increase their annual profits by 50% or more. More than 60% of the companies which receive private equity funding manage to increase their annual profits by 20% or more.
Companies which receive private equity funding are generally focused on long-term growth. They can afford to take risks and implement radically different growth strategies without worrying about short-term gains. Moreover, as an investor, you can play an active role in accelerating the company’s growth (in case of venture capital funding or growth equity funding) or turning the company around (in case of restructuring capital or buyout capital).
There are many ways in which you can invest in private equity.
Private equity firms invest in start-ups, growing companies, or distressed companies. These firms have a small group of investors who put in a substantial amount of money, cash which then gets invested in a number of companies.
Private equity firms, however, tend to have very steep barriers to entry. They generally look for high net worth individuals who can afford to invest anywhere from $250,000 to $25 million.
Private equity fund of funds
These are funds which hold the shares of private partnerships which primarily invest in private equities. Due to the diverse nature of their investments, these funds can add a lot of value to your investment portfolio and boost your long-term returns.
As is the case with private equity firms, these types of funds also have entry barriers, which might be beyond the reach of many investors. Many of these funds require you to have a net worth between $1 million to $5 million (excluding the value of your home) in order to be able to participate.
They also have minimum investment requirements, which can range from $100,000 to $250,000.
Private equity exchange-traded funds
These are exchange-traded funds (ETFs) which are designed to follow a market index of publicly traded companies which make private equity investments in different sectors and industries.
The unique selling point of private equity ETFs is that they do not have any entry barriers. There are no minimum investment requirements and you do not have to be a high net worth individual in order to be able to invest in these funds.
These funds are highly liquid in nature, which means you can buy and sell them any time you want. You are required to pay a brokerage fee every time you buy or sell shares.
Special purpose acquisition companies
These are publicly traded companies which provide private equity funding to privately owned companies which are undervalued. Your investment in SPACs could fetch decent returns if the companies they invest in perform well. Otherwise, your investment could lose value.
Moreover, unlike private equity firms or fund of funds, SPACs do not make a series of investments in companies operating in different industries. Instead, they tend to invest a large sum of money in one company.
The lack of diversification certainly poses a risk and it is a factor you should consider before investing in a SPAC.
The bottom line on private equity
Private equity investments are generally expensive and typically have a seven to 10-year investment horizon. If you can meet the minimum investment requirements and afford to wait for several years, you can make your investments through a private equity firm or a fund of funds.
If you are a regular investor, you can choose to invest in a private equity ETF, which allows you to invest as little or as much as you want and can be easily bought and sold through brokerage firms.