It is well-known that proper diversification is the key to portfolio risk management. Many investors use mutual funds and ETFs in their portfolios to gain a diversified mix of individual stocks and exposure across asset classes. With a standard retail brokerage account, individual investors can gain access to traditional equities and most other major asset classes like fixed income, emerging markets and commodities to name a few.
However, one area that has traditionally been out of reach for most individual investors is the private markets. Typically “private markets” refers to private equity and its subset, venture capital. Access is still relatively limited to higher net worth individuals, but new technologies aimed at democratizing access to private equity have opened up more opportunities to investors in this space. Although private equity is traditionally associated with higher fees and illiquidity, the asset class is worth examining as historically private equity has outperformed public markets over the long run.*
What is Private Equity?
Private equity is an alternative investment class made up of non-liquid investments in primarily private companies not listed or traded on public exchanges.
The most common way to invest in private equity is through a fund, although direct investments and co-investments are other less common approaches. Investments in private equity are typically structured as limited partnerships. Private equity managers serve as the “general partners” and are responsible for executing and operating the investment. Investors provide capital and serve as the “limited partners”. Limited partners are usually institutional accounts, pension funds, or high-net worth individuals.
Private equity managers pool investors’ capital through private equity funds to make investments in private companies. They attempt to create value by improving a company’s financial and operational performance, with the goal of exiting the investment for a large gain. There are different types of private equity strategies that more specifically define the type of investment approach such as venture capital, growth capital, leveraged buyouts, and real assets.
Characteristics of Private Equity Funds
These are some of the main characteristics of private equity funds:
- They are a defined term investment with a long time horizon. Committed capital is locked up for a period of time, typically 10 years. The committed capital is called over the first few years as opportunities in portfolio companies are identified.
- The J-Curve effect. This represents the typical cash flow patterns of private equity funds. Private equity funds often show negative returns in their early stages as capital goes toward portfolio company acquisition costs and fund fees, with the anticipation of gains in later years once investments have had the time to mature and be realized.
- Illiquidity. Private equity investments are long-term investments that typically have little to no secondary market and must be held until the end of the agreed term.
- They are actively managed investments. Private equity managers require expertise in their niche as they take on active investor roles in companies.
- There is the potential for higher returns and improved diversification. This is due to the unique characteristics associated with private equity when compared to public markets.
Private Equity Fees
Private equity is a complicated asset class that requires investor expertise and a strong skill set. Private equity managers are usually highly compensated for their investment sourcing abilities and access to strong investment opportunities.
Private equity funds structure their fees similar to hedge funds, and generally have an annual management fee and a performance fee (carried interest). Management fees typically range from 1.5%-2%, and performance fees are usually 20% of profits. Private equity funds also usually have a preferred rate (hurdle rate) which is an annualized rate of return that must first be met before performance fees can be assessed. An 8% hurdle rate is typical but can vary by fund.
Is Private Equity Right for My Portfolio?
Investing in private equity can offer benefits to your portfolio such as higher return potential and increased diversification that may not be accessible in public markets. It is important to point out that private equity investments are not appropriate for all investors and come with higher risks and fees. Before investing, an individual’s financial situation, investment objectives, risk tolerance, time horizon, liquidity needs, and investment knowledge should be assessed to determine if the investment is appropriate.
For clients with at least $5 million invested with Personal Capital, we are excited to be able to offer a simple, cost efficient way to participate in private equity as part of a holistic financial plan. Private equity is a complex asset class, which is why we strongly believe in the importance of our fiduciary approach focused on client outcomes.
We recognize that this option is still unavailable to the vast majority of investors, including many of our clients, and hope to be able to offer something similar to more people over time.
If you are interested in learning more about this opportunity or any of the ways we are helping people improve their financial lives, schedule a call with a Personal Capital advisor through our online scheduling app.
*Source: Cambridge Associates; data as of March 31, 2018.
Disclaimer: Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital Corporation. Personal Capital Advisors Corporation is a registered investment advisor with the Securities Exchange Commission (“SEC”). SEC registration does not imply a certain level of skill or training.