What Is Private Equity?

Private equity refers to equity investments in companies that aren’t publicly traded. Typically, private equity firms pool resources of wealthy individuals and institutions to create an investment fund that then invests in companies that are not publicly traded. There usually is a very high minimum investment and hefty fees to invest. Additionally, holding periods can be years, and the risk of failure isn’t insignificant.

How Does One Invest in a Private Equity Fund?

Directly investing in a private equity fund is not accessible to the average investor. Private equity firms typically require investors to invest a minimum of anywhere between $250,000 and $25 million.

Investing in a “fund of funds,” which invests in many private equity firms, is more attainable. Minimum investment can be as low as $100,000, but managers may not let investors participate unless they have a net worth between $1.5 million and $5 million. A fund of funds offers greater diversification, since it can invest in hundreds of companies representing many different phases of venture capital and industry sectors. Additionally, because of its size and diversification, a fund of funds has less risk. The disadvantage is there is an additional layer of fees paid to the fund-of-funds manager.

Another route to investing in private equity is to purchase shares in an exchange-traded fund (ETF) that tracks an index of publicly traded companies investing in private equities. Shares are purchased in the stock exchange, so there are no minimum investment requirements. However, the ETF will add yet an extra layer of management expenses, and each time shares are bought and sold, there are brokerage fees.

Evaluating Opportunities and Risks

Key questions to ask prior to investing in private equity include:

  • How much will fees reduce overall returns? Private equity fees are higher than those charged by public equity managers. Fees include a management fee component, ranging from 1.5% to 2% of the commitment amount and a share of the total profits, which is typically 20%. When investing in a fund of funds, there’s an additional layer of fees, and if the investment is made via an ETF, there’s an additional layer yet.
  • Will adding private equity add value? Private equity is touted as having low correlation to publicly traded stock, lessening volatility and risk. Some financial experts, however, dispute this.
  • Will the money be needed anytime soon? Private equity firm and fund-of-funds investments are illiquid for a period of time and typically have a 10-year investment horizon. This investment period can be stretched further in difficult market cycles.
  • Can the portfolio stand the concentration? Private equity fund investments are concentrated; a typical private equity fund will have 10 to 20 portfolio companies per fund. This level of concentration means there is more idiosyncratic risk, or risk that a single company failure will heavily impact the overall fund return. High minimum investment amounts also can make it difficult to diversify across multiple funds.
  • Is the risk worth it? Many financial experts argue that because private equity firms have proliferated over the past couple of decades, it’s become more difficult for private equity firms to locate excellent investment opportunities. Thus, overall returns going forward will not be equivalent to those seen in the past.
  • What’s the investment history? Many newer private equity investment vehicles with lower minimum investment requirements do not have long histories to use to compare them to other investments.
  • What other risks are there? Firms specializing in certain industries carry further risk particular to a certain sector.

Due Diligence

Additionally, when evaluating a private equity firm, key items to understand and review in the due diligence process are:

  • Background of the firm and partners.
  • Status of the general partner.
  • Investment strategy.
  • Deal flow.
  • Company-level due diligence capabilities.
  • Performance track record.
  • Terms of the proposed fund.

The Bottom Line

Private equity potentially can provide returns in excess of public market equities, but it also comes with a high degree of risk. Diversification in private markets is just as important as it is in public markets. Like any financial decision, it is important to consult your financial advisor to discuss your individual circumstances and whether this type of investment is appropriate for you.

Questions? Contact an MCB Advisor at 703-218-3600 or click here. To review our private equity articles, click here.  To learn more about MCB’s tax practice and our tax experts, click here.

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