Written By: Martin Stein
Front-row seats to Game 7. An 8 o’clock reservation for a five-star restaurant’s opening night. Backstage passes to The Rolling Stones. Private equity.
A lot of the most exciting things in life aren’t accessible to everyone. But sometimes, like private equity, it’s the best option if you can swing it. PE also has its downsides, so you should be fully aware of the pros and the cons as you decide whether to jump into the fray.
Investing in private equity can be rewarding and lucrative for many investors, but it’s important to get clear on how it works and what options are available.
The ABCs of PE
PE is generally a subsection of alternative investments, an eclectic group that includes real estate and hedge funds — as well as comic books, wine, collectible coins, and whole life insurance policies.
Private equity is then divided into two major categories: leveraged buyouts, or LBOs, and venture capital. LBOs refer to mature, later-stage transactions, whereas venture capital deals with early-stage transactions. LBOs are a natural for PE, because it is funded almost entirely by accredited investors who are able to combine financial resources to purchase companies.
This approach has worked: A glut of articles out there espouse PE’s meteoric rise over the past three decades. And that trajectory has intensified in recent years: Private equity has raised more than $3 trillion since 2012. Venture capital has done particularly well recently, too, with funding reaching $84.2 billion in 2017 alone — and no signs of slowing down.
Whether investing in industry, in healthcare, in small or large companies, PE continues to generate sizable value for investors.
The Wealth Requirement of PE
It is often thought that one needs to be quite wealthy to invest in private equity. Although some laws establish minimum net worth requirements to become an investor in private equity, there are ways to circumvent that restriction — to some degree.
One is by investing in publicly traded PE firms such as Apollo Global Management (APO[NYE] – $23.41 Trade ), The Blackstone Group (BX[NYE] – $27.60 Trade ), The Carlyle Group (CG[NGS] – $15.32 Trade ), and KKR & Co. (KKR[NYE] – $19.35 Trade ) or in “business development corporations” such as Capitala (CPTA[NGS] – $7.16 Trade ), Prospect Partners, Triangle Capital (TCAP[NYE] – $0. Trade ), and about 20 more.
That’s because BDCs serve a useful role for investors: investing in small businesses that are often left out of speculative investment capital or even commercial banks. “Small” is a relative term, of course, and may mean companies with sales beyond $100 million each year. BDCs invest in well-known companies, too, such as Payless Shoes and the late Toys”R”Us.
For those wishing to directly invest in PE, yes, there is a requirement of net assets, which is defined by the U.S. Securities and Exchange Commission’s Regulation D. This stipulates that investors must have shown themselves to be financially sophisticated enough to not require protection through filing regulatory disclosures — and are therefore “accredited investors” who have proven themselves capable of assuming the financial risk.
An investor can demonstrate that in several ways: a net worth of $1 million (excluding the value of one’s primary residence); yearly earnings over $200,000 single or $300,000 joint; or serving as a top leader in a company that issues unregistered securities. Roughly 8.25 percent of American households — just over 10 million — qualify as accredited investors. If you’re in the 91.75 percent of Americans who don’t meet these wealth requirements, there is a workaround of sorts: to participate in PE through a pension.
If you are considering actively investing and choosing where your assets will be deployed, it’s important to think carefully in terms of risk.
What to Consider Before Jumping In
Given all these opportunities for generating additional value, PE investing remains an attractive option for many investors. For that reason, let’s look at a few actionable strategies for those looking to broaden their portfolios into this area.
1. Determine whether alternative investment vehicles are for you.
Before you consider investing in PE, you must decide whether you want to commit to a component of your portfolio that is likely to generate significantly higher returns — but with the downside of proportionally higher risk.
Fundamentals when it comes to PE investing aren’t different from basic investing acumen; there’s a relationship between risk and reward. Low-risk investments like CDs, money markets, or Treasury bonds will always generate rather modest returns, around 1 to 2 percent. With public equities, it’s not uncommon to see average returns more like 5 to 9 percent. But with PE, investors take on greater risk — for more potential rewards. Bulge bracket PE investors can often see 15 percent ROI; lower middle-market investors can enjoy 20 percent; and later-stage venture capital can break 25 percent. Startups, with the greatest degree of risk, can often return 35 percent or more.
Other drawbacks to PE investments are that they’re generally illiquid, meaning you can’t sell them, unlike stocks and bonds; they’re longer-term holds, meaning five to seven years in a company and oftentimes eight to 14 years in a fund; and they’re volatile, meaning they can (and will) vary.
2. Select the appropriate allocation.
For most PE investors, this number varies from 1 to 20 percent of your total investable assets. Rarely would asset managers suggest allocating greater than 20 percent, except in extraordinary circumstances.
Those circumstances might include direct investment in a company or property with which you have some influence and can exert some control; investment in a PE fund with which you have a special relationship; a higher appetite for risk; or some combination of these.
You’ll also need to establish the exact PE firm or type of fund in which you will invest — big or small, industry or regional focus, investment or business model type, etc. These decisions require due diligence and good research.
3. Be a responsible investor.
The rules here are similar to any type of investing. Pay attention to the performance of the company. Don’t overreact to ups and downs — and don’t “under-react,” either. Be prepared for volatility, but also enjoy what should be higher-than-expected returns of 15 percent or more.
For those investors who match well with PE, it can be a very rewarding aspect of your overall investment strategy.
Martin Stein is the founder and managing director of Blackford Capital, focused on dramatically transforming lower middle-market industrial enterprises through exponentially profitable growth. Since receiving his Bachelor of Arts from University of Chicago and his MBA from Harvard Business School, he has had almost two decades of private equity experience. Among other awards, Martin has been honored as the nation’s Private Equity Professional of the Year by M&A Advisor.
DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer
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