Is Private Equity a Good Investment?
Private equity investments are increasingly popular. So, should wealthy families be making private equity investments?
This post highlights some reasons why investors should avoid private equity.
What is Private Equity?
Private equity simply refers to investing in companies that are privately owned compared to investments traded on exchanges (like stocks).
Most investors use private equity funds rather than invest in private companies directly.
Private equity funds buy, typically re-position, and then sell shares in private companies. Private equity funds might also buy public companies and then take them private to re-organize them. These private equity funds charge a fee for their service like any other investment fund.
Private equity might seem appealing to some, but there are lots of reasons why investors should avoid private equity.
Here are three main reasons:
- Reaching most investment goals doesn’t require private equity
- Private equity investing is expensive (in both money & time)
- Private equity is opaque (less disclosure, less transparency, more conflicts of interest, limited price discovery)
Let’s go over these reasons in more detail.
Reason #1 – Reaching most investment goals doesn’t require private equity
Consider the main goals of most wealthy investors:
- Generate income to support lifestyle
- Support family legacy
- Support philanthropic legacy
These goals can be achieved without private equity.
Once an investor can generate enough income to sustain their lifestyle from the dividends & interest of their investment portfolio, they are wealthy. No investor becomes wealthy by private equity investing. Quite the opposite. Private equity is pitched to investors who are already wealthy. Only the managers of private equity funds become wealthy from private equity investing.
To become wealthy, investors will either need to create wealth through entrepreneurship or inherit it. Generating income to sustain a wealthy investor’s lifestyle can be achieved using a simple portfolio of public market stocks, bonds, and real estate investments.
Private equity will not help investors achieve their goals.
Reason #2 – Private equity investing is expensive
Simple index funds can be obtained for almost no cost and they are guaranteed to produce a market rate of return. Whereas most private equity funds charge a base management fee of 2% and typically charge a performance fee of 20% without any guarantees.
The “2 & 20” fee structure is expensive and clearly benefits the private equity fund managers at the expense of their investors.
Reason #3 – Private equity is opaque
Public companies traded on stock exchanges are required to make detailed disclosures to their investors. These disclosures include regular standardized financial reports and a wide range of disclosures relating to environmental, social, and governance topics.
Private companies aren’t required to disclose many details to their own investors at all. Leaving them in the dark most of the time.
Its not always clear to private equity investors how their investments are performing until the end of an investment’s life.
Since private company shares are not traded on a public exchange like stocks are, its impossible for investors to determine an private equity investment’s market value at any specific point in time.
Only at the end of a private equity investment’s life is it possible to determine whether it has been a good or bad investment. And by then, its too late.
So, why are investors drawn to private equity?
If private equity investments are so bad, why are so many investors drawn to them?
Here are three reasons why some investors love private equity:
Since the fees for private equity funds are so high, they can afford to spend a lot on marketing. Private equity firms are notorious for having lavish offices, flashy outfits, and slick marketing materials. Guess who pays for all of this? Investors.
Part of the high fee investors are paying for private equity is being used to support the sales efforts of private equity firms.
Regulators have supported this trend.
Regulators have made rules restricting private equity to so called “accredited investors”. These rules exclude most retail investors from making private equity investments. In turn, it has provided a certain exclusivity to private equity as the “domain of the wealthy”. Thereby increasing its appeal & mystique.
Instead of private equity, investors could simply use index funds. Right?
By using low cost index funds, investors are guaranteed a market rate of return. But for many, getting the “average” is not very exciting. Those investors might be drawn to private equity for hope. Because, at least there is a chance of outperformance. Hope is appealing, even if the chance is far fetched.
When should private equity be used?
Are there situations when private equity might be a good investment? Yes.
Many wealthy investors have goals that are not based on economic returns. These investors might be able to satisfy their own material consumption with only a small portion of their capital. This enables them to devote more of their capital towards achieving other social, environmental, and charitable goals.
These investors are sometimes called “impact investors”.
Impact investors will probably find that stocks and other public market investments will not help them achieve their goals. This is because for impact investors, “good” economic returns are not necessarily useful. What might be more important for impact investors is supporting other non-economic values.
For example, say a wealthy impact investor wants to promote gender diversity. They want to see more women entrepreneurs and more women in leadership roles. Well, there are venture capital and private equity funds specifically designed to achieve these goals. The same is true for many other environmental and social goals.
Impact investors might like venture capital and private equity because of a focus specifically towards achieving impact goals. These goals might not be possible to achieve using public market investments such as stocks.
So, for many impact investors, private equity could be quite useful.
Our Family Office
Our family office tends to rip on expensive investment services an focus instead on delivering measurable value to our clients.
Determining what your financial goals are is the first best place to achieving financial success. Whether you should invest in this thing or that can be outlined in an investment policy statement (“IPS”). This IPS can guide your investment decisions and help you cut through the investment clutter.
Our family office will write an investment policy for your family that will provide clarity and purpose to your financial life. Many investors might be surprised to learn they can achieve their financial goals with a simple, transparent, and easily repeatable investment process.