What’s in a Word: Private Equity
In my work at PENSCO, I help clients navigate the ins and outs of holding private equity in their self-directed IRAs. What is very apparent to me is that private equity means different things to different people, and it can be a confusing term for investors who are new to the asset class.
At a high level, private equity (which can also be referred to as a private placement) is a broad category that encompasses a variety of assets, ranging from private hedge funds and private non-traded REITs, to debt instruments of private companies. A common characteristic linking them together is that they are non-traded assets, which means they are not publicly traded on a stock exchange.
Private equity (PE) offers the potential of high absolute returns and portfolio diversification. PE returns have historically been very competitive with other asset classes. According to the Private Equity Growth Capital Council, private equity returns averaged 14.0% annually over the past decade, significantly exceeding S&P 500 returns of 8.1%.
According to the Private Equity Growth Capital Council, private equity returns averaged 14.0% annually over the past decade, significantly exceeding S&P 500 returns of 8.1%
Most private equity funds are structured as closed-end investments with a typical fixed term of seven to ten years. Investors commit cash at the fund’s inception, which is drawn down over the life of the fund, and investors receive their payback at the end of the fund’s term when its holdings are liquidated.
The private equity market is expected to grow from $3.6 trillion currently to between $6.5 trillion and $7.4 trillion by 2020, according to financial services firm PwC. Today, the main holders of private equity are pension funds, endowments, foundations and other large institutional investors. That could shift over time as individual investors demand access to assets beyond stocks and bonds, and equity crowdfunding rises in popularity.
If you are new to the world of PE, how do you begin to figure out what type of investment might fit your investment needs? One way to think of the wide world of private equity is to look at it as two broad categories:
- PE investments with a single focus
- PE investments with a commingled focus
PE investments with a single focus tend to invest in one specific company or sector, or with a specific purpose such as funds that limit their investment to LLCs, LPs, options, warrants or foreign private equity.
The private equity market is expected to grow from $3.6 trillion currently to between $6.5 trillion and $7.4 trillion by 2020, according to financial services firm PwC
The second category is made up of funds that invest in multiple assets, or commingled funds. Their diversified portfolios can include a mix of private hedge funds, funds of funds, exchange-traded funds, and private and non-traded REITs.
If you consider yourself to be risk-adverse, you might gravitate toward a diversified fund that mitigates risk by investing in a pool of assets. If part of the portfolio performs poorly, it might be balanced by another part of the portfolio that performs well or better-than-average.
But if you’re a more aggressive investor or you have a strong conviction about a particular opportunity, you may prefer investing in a fund that concentrates on a specific company or purpose. This approach maximizes potential reward – although it involves more risk.
Investors should understand the potential risks that come with investing in this asset class. Private equity funds keep much of their investment information confidential, so performing your due diligence and comparing the performance of various fund managers may prove challenging. Fund start-offs can also take the form of “blind pools” that allow no previewing of assets before investing,
In addition, private equity investments are not easily liquidated and investors must often wait several years to realize returns. Some funds return a portion of investor cash through distributions, but the amount and timing of payments can be uncertain.
Private equity funds may not be right for every self-directed IRA. But for those with a long investment horizon who are comfortable with longer holding periods, it may offer portfolio diversification benefits and the ability to outperform more traditional asset classes.
PENSCO’s Blog is purely for educational purposes. PENSCO does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Individuals are encouraged to seek professional advice before making any investment decision. Investments are not FDIC insured and are subject to risk, including the loss of principal.