By Peter Mastrantuono
Money has been pouring into private equity. According to Bain & Company, a global consultancy, private equity assets swelled in 2018 to close out the best five-year stretch in the industry’s history.
Private equity is an umbrella term encompassing a wide range of investment opportunities, including leveraged buy-outs, investing in private companies, distressed funding, venture capital, real estate and financing growth opportunities in exchange for an equity stake.
Private equity, which generally adopts a limited partnership structure, is considered an alternative investment, and as the name implies, shares are not publicly owned, nor quoted or traded on a stock exchange.
Investment in private equity by individuals is limited to those who can meet the income and net worth requirements of an “accredited investor,” as defined by the Securities and Exchange Commission.
The rise of private equity can be explained by several key benefits it offers investors, namely, an added level of diversification for traditionally diversified portfolios, access to investment opportunities not available to the general investing public and the superior returns it has historically delivered.
Before jumping on the private equity bandwagon, high net worth investors need to be aware of some very significant caveats.
Private equity vehicles are highly illiquid. Consequently, investors need to be prepared to lock up their investment for many years, with no guarantee that any anticipated exit date will be met on a timely basis.
Moreover, companies in the private market are valued quite differently from how companies are valued in the public markets. In the private market, pricing is determined by negotiation between the investor and the company, while publicly traded stock prices are arrived at by the interaction of many buyers and sellers. This negotiated approach to pricing can lead to significant downside valuation adjustments when exiting an investment, as witnessed with some recent high profile IPOs.
Additional areas of concern include restrictions of shareholder rights (typically not on par with public companies) and higher fee structures charged by managers of private equity funds.
While the historical outperformance of private equity is well established, there are reasons to question whether this relative outperformance can continue.
The first concern is that the surge in new funds into private equity may be outstripping the available opportunities to the degree that it may hurt future performance results.
Another consideration is the point at which markets may be in the valuation cycle. Market prices generally travel from undervaluation to fair valuation and then to overvaluation. Investing at the wrong time in this valuation cycle can hurt long-term returns.
Finally, outperformance in any marketplace, including private equity, is often the result of inefficiencies in that market, which highly capable money managers can exploit. As this market inefficiency gains greater visibility and more managers enter the space, these inefficiencies can evaporate, leaving less room to reap outsize gains. Furthermore, this growing participation often includes the entry of less capable managers.
Private equity may remain an attractive investment alternative, but it pays to work with a financial advisor who can help find suitable private equity investment opportunities, provide advice on the appropriate allocation of private equity in an overall portfolio and determine the best timing to commit money.
Peter Mastrantuono is a contributing writer to www.myperfectfinancialadvisor.com, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.