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Know the Risks to Reap the Rewards of Private Equity Investing

The Securities and Exchange Commission (SEC) is exploring ways to allow more individuals to participate in private equity investing. This initiative is still in its early stages but there appears to be considerable momentum. Yet it is important to keep in mind that there are serious risks in private equity.

A businessman holds a holographic logo that says "private equity."
A businessman holds a holographic logo that says "private equity."

Source: Alfa Photo/ShutterStock.com

Before looking at these, let’s do a quick refresher. Private equity is a massive asset category and allows for participation in a variety of different strategies. Here are some examples:

  • Hedge Funds: These use sophisticated techniques like algorithmic trading and arbitrage to get higher returns.

  • Buyout Funds: This is where private or public companies are acquired, usually with large amounts of debt. The buyout fund will look at ways to streamline operations to increase cash flows to handle the interest payments. The goal is to ultimately sell or take public the portfolio companies.

  • Venture Capital Funds: This involves investing in startups — usually in technology or biotechnology companies — that have significant growth opportunities. The exits include acquisitions and IPOs.

To participate in a private equity fund, you need to be accredited. This means either your annual income is $200,000 per year ($300,000 if you’re married), or you have a net worth of $1 million (this does not include your residence).

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As for the SEC’s proposal for new rules, they will still maintain this requirement. However, there will also be provisions for those persons who have knowledge of investing, say by having a securities license.

Keep in mind that anyone can invest in some of the private equity firms that manage funds. Examples include KKR & Co (NYSE:KKR), Blackstone Group (NYSE:BX) and Carlyle Group (NASDAQ:CG). These firms earn their profits primarily from the funds they manage. They also generally have high dividend payouts.

Private Equity Risks

Private equity investments have numerous advantages. First of all, they’re diversified, which helps mitigate the fallout from failed deals. Next, a fund has the benefit of experienced managers who can seek out investment opportunities. Finally, the returns can be magnified with debt.

Then again, there are certainly some notable risks to consider. Let’s take a look:

  • Quality: Access to the world’s top private equity funds is often limited. As a result, for retail investors, the types of funds available will likely be the newer ones or those that have average or subpar performance track records.

  • Taxes: Funds are usually structured as partnerships. Because of this, the taxes can get complicated, such as having to a filing called a K-1. This may mean having to hire a qualified tax professional.

  • Time Frame: A typical fund will not start returning any meaningful money until five years or more. In fact, there may be restrictions on when an investor can sell his or her position.

  • Market Cycles: A big factor of the success of a private equity fund is the timing. For example, among those funds that started during the end of frothy periods – like 1999-2000 and 2006-2007 – they usually have had poor returns.

  • Transparency: Funds may not provide in-depth disclosure of their strategies. After all, this information may be considered proprietary. But this can make it difficult to evaluate a fund. In some cases, the lack of sufficient transparency can make it easier for a manager to perpetuate a fraud, such as by hiding losses.

  • Leverage: Some funds may have high levels. But yes, this can mean the potential for a wipe out. There have been high-profiles examples of this like Long-Term Capital, which actually required the intervention of the Federal Reserve.

  • Fees: These can be hefty. Not only are there management fees (that can range from 1% to 2% of the assets under management) but also a percentage of the earnings (they can be 20% to 25%).

Bottom Line On Private Equity

While it is difficult to predict how the rules may change, they will likely get more lenient in the years ahead. We’ve already seen this with areas like crowdfunding.

“Investing your money in anything generally comes with a certain level of risk,” said Justin Halldorson, who is the Managing Partner at Shift Capital. “Private equity is no exception.  Those who are looking at private equity to diversify their portfolio will have to do a bit more homework than they are used to in order to find opportunities that are suitable for their unique risk tolerance.”

Tom Taulli (@ttaulli) is an advisor/board member for startups and author of various books and online courses about technology, including Artificial Intelligence Basics, The Robotic Process Automation Handbook and Learn Python Super Fast. He is also the founder of WebIPO, which was one of the first platforms for public offerings during the 1990s. As of this writing, he did not hold a position in any of the aforementioned securities.

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