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.