Investing in private equity (PE) can seem like an exclusive club for the wealthy and well-connected.
Let’s talk about private equity and its relevance to your investment strategy. We will explore the advantages and disadvantages in simple terms to showcase the impact of effective financial planning.
What is Private Equity?
Private equity involves investing in companies not listed on public stock exchanges. PE firms raise money from investors to buy stakes in these private companies to improve their value and sell them for a profit.
What are the benefits of investing in Private Equity?
High Potential Returns
One of the biggest attractions of private equity is the potential for high returns. Successful private equity investments can outperform the stock market. For instance, big Private Equity firms like Apollo and Blackstone have had notable successes that brought in billions.
Access to Unique Investments
Private equity allows investors to get involved in unique opportunities unavailable on the public market. This can include investing in cutting-edge technologies or turnaround projects that need intensive management and financial restructuring.
Illiquidity Premium
Private equity investments are often illiquid, meaning you can’t easily sell them quickly. This illiquidity can sometimes lead to higher returns as investors expect to be compensated for the risk of being unable to sell their investments quickly.
What are the drawbacks of investing in Private Equity?
High Fees
Private equity can be expensive. The managers of private equity funds charge significant fees, which can eat into the returns. Studies have shown that while gross returns (before fees) can be substantial, the net returns (after fees) may not always justify the investment compared to public markets.[1][2]
Lack of Transparency
Private equity investments may lack the transparency of public markets. The value of these investments isn’t updated as frequently, making it harder to know how they are performing at any given time. This can be misleading, as these investments may be more volatile than they are.[3]
Risk of Misleading Metrics
Metrics such as Internal Rate of Return (IRR) can be misleading. They often reflect high returns based on early successes, but these figures do not always provide a true picture of ongoing performance. This makes it difficult to compare private equity returns directly with stock market returns.[4][5]
Illiquidity
While illiquidity can lead to higher returns, it also means your money is locked up for an extended period. This can be a significant disadvantage if you need quick access to your funds. The inability to sell your investment quickly can pose a considerable drawback for many investors.[6]
Do I need to invest in Private Equity?
While private equity can offer high returns, like most complex investments, it is unnecessary for most financial plans. Here’s why:
Sufficient Returns from Public Markets
Global equities, which are publicly traded stocks worldwide, can provide adequate returns for most investors. Over the long term, diversified portfolios of public equities have delivered strong performance, making them a solid choice for building wealth.
Lower Costs
Investing in publicly traded equities through low-cost index funds involves significantly lower fees than private equity. This means more of your money stays invested and working for you.
Liquidity and Flexibility
Publicly traded equities offer liquidity, meaning you can buy and sell them quickly. This flexibility allows you to adjust your portfolio, access your funds in emergencies, and avoid being locked into long-term commitments.
Simplicity and Transparency
Publicly traded equities are more straightforward and transparent than private equity. They are subject to strict regulatory oversight, and information about companies is readily available, making it easier for investors to make informed decisions.
Private equity can be an attractive option for those with the resources and knowledge to navigate its complexities and risks. However, for the average investor, sticking to a well-diversified portfolio of global equities is likely a smarter, more cost-effective, and safer route to financial success. Remember, the key to successful investing is not necessarily finding the highest returns but ensuring your investments align with your financial goals, risk tolerance, and need for liquidity.
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[1] Harris, Robert S. and Jenkinson, Tim and Kaplan, Steven Neil and Stucke, Rüdiger, Has Persistence Persisted in Private Equity? Evidence from Buyout and Venture Capital Funds (March 30, 2022). Fama-Miller Working Paper, Available at SSRN: https://ssrn.com/abstract=2304808 or http://dx.doi.org/10.2139/ssrn.2304808
[2] Erik Stafford, Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting, The Review of Financial Studies, Volume 35, Issue 1, January 2022, Pages 299–342, https://doi.org/10.1093/rfs/hhab020
[3] Phalippou, L. (2020). An Inconvenient Fact: Private Equity Returns & The Billionaire Factory. Journal of Finance.
[4] HARRIS, R. S., JENKINSON, T., & KAPLAN, S. N. (2014). Private Equity Performance: What Do We Know? The Journal of Finance, 69(5), 1851–1882. https://doi.org/10.1111/jofi.12154
[5] Harris, Robert S. and Stucke, Rüdiger, Are Too Many Private Equity Funds Top Quartile? (Fall 2012). Journal of Applied Corporate Finance, Vol. 24, Issue 4, pp. 77-89, 2012, Available at SSRN: https://ssrn.com/abstract=2193855 or http://dx.doi.org/10.1111/j.1745-6622.2012.00402.x
[6] Welch, Kyle Travis. “Private Equity’s Diversification Illusion: Economic Comovement and Fair Value Reporting.” Working Paper, January 2014.
