Pros and Cons of Private Equity Investing

Sheet of paper with "Private Placement Memorandum" printed across the top, representing an investment in private equity

For some investors, the traditional asset categories of stocks, bonds and cash equivalents aren’t enough to ensure a well-diversified portfolio. When this occurs, individuals may want to consider turning to alternative assets in the private market space.

These are investments that don’t fall into one of the three traditional asset categories. Some of the most common alternative assets are private equity, private debt, private real estate, and hedge funds.

For the most part, private market funds have been regulated much less than assets in the public market. That’s because high-net worth investors are considered to be better equipped to sustain potential losses than average investors.

In this series of articles, we will take an in-depth look at each of these alternative assets to help you decide if they are a wise choice for you, starting with private equity.

What is Private Equity?

As the name implies, private equity is an ownership stake in a company that is privately held. This is in contrast to public equity, which is an ownership stake in a company that is traded on one of the public stock exchanges, like the New York Stock Exchange or the Nasdaq Composite.

Private equity firms create private equity funds by forming a limited partnership. Investors in the fund become Limited Partners by contributing money to a pool that’s used to invest in private companies that meet the fund’s investment strategy. The private equity firm is the General Partner and assumes responsibility for managing the fund’s investments, performance reporting (usually on a quarterly basis) and operational tasks of running the fund.

Private equity funds are illiquid investment vehicles that contain privately held companies. They require long capital lockups (typically 8 to 12 years or longer) and are not marked to market each day. Private equity fund sub-asset classes include:

  • Leverage Buyout (LBO)
  • Growth Equity (GE)
  • Venture Capital (VC)
  • Distressed/Special Situations

Benefits of Private Equity

So what are the benefits of investing in private equity? One of the biggest benefits is enhanced portfolio diversification, which can help lower overall portfolio risk.

Another potential benefit is higher returns. Private equity returns compare favorably with other asset classes on several different levels, including public equity. Private equity offers a historical risk premium over public equity. Here is how private equity has performed relative to public equity over recent time periods, as measured by the MSCI World Index (public equities) and the Global PE Index (private equities):

5 Years10 Years15 Years20 Years
Private Equity13.4%9.5%14%12.2%
Public Equity9.9%6.3%8.1%5.2%

Since private equity firms actively manage their portfolios, they charge higher fees. So some have argued that private equity actually underperforms public equity on a net basis after fees. However, a study performed by JP Morgan determined that private equity still outperforms public equity even when fees are taken into consideration.

Risks of Private Equity Investing

It’s important to remember that there are unique risks involved with private equity investing. For starters, private equity is an illiquid investment with long duration holds and investment time horizons, which may delay cash flow. Limited Partner interests are not redeemable and can’t easily be sold to an outside Limited Partner.

Private equity is an inherently speculative investment, with portfolios highly concentrated in just a few investments. Investment strategies rely on fund manager assumptions when underwriting investments, and performance dispersions among private equity fund managers are much wider than in the public markets. Managers can’t be replaced during the fund life.

Private equity investing also requires investing in a “blind pool.” In other words, the specific investments usually aren’t known at the time of commitment. There are also usually high minimum investment requirements that make it difficult for some individuals to invest.

Why Private Equity Historically Outperforms

So why are private equity returns historically higher than other asset classes? One reason is that investors have access to a much larger pool of companies to invest in. There is a limited selection of public companies and these companies face heavy scrutiny by investment analysts. For example, there are about 200,000 companies in the U.S with more than $10 million in annual revenue, compared to about 6,000 publicly traded companies this size.

Private equity firms have access to this large pool of lesser-known companies that may present unique opportunities for high returns. These firms also have the resources to carefully study these companies to decide which meet their investment criteria. There does tend to be more risk in investing in lesser-known companies, but the potential rewards are higher.

Another factor is the active ownership role played by private equity firms in the companies they invest in. This may range from advising and assisting management to restructuring and running the company. The goal of private equity firms is to add value to each company they invest in.

How We Can Help

The team at C.W. O’Conner Wealth Advisors works closely with investors to determine if alternative assets, including private equity, are appropriate based on goals, time horizon and risk tolerance. Call us directly at 770-368-9919 or email Cliff at cliff@cwoconner.com or Kevin at kevin@cwoconner.com to learn more.

Cliff is the founder and president of C.W. O'Conner Wealth Advisors, Inc. Cliff earned a Bachelor of Business Administration degree in Accounting from Georgia State University.

Kevin O'Conner is a financial planner with C.W. O'Conner Wealth Advisors, Inc. He earned a Bachelor of Business Administration degree in Business Management from Georgia College, and is a Certified Investment Management Analyst (CIMA).