Private equity is capital made available to private companies or investors. The funds raised might be used to develop new products and technologies, expand working capital, make acquisitions or strengthen a company's balance sheet.

Unless you are willing to put up $250,000 or more, your choices in investing in the high-stakes world of private equity are very limited. In this article, we'll show you why and where you can invest in the private equity game.

SEE: Life-Cycle Funds: Can It Get Any Simpler?, Advantages Of Mutual Funds and The Dangers of Over-Diversification.)

Why Invest in Private Equity?
As you can see from the chart below, private equity is on the upswing, in spite of 2008's crisis:

U.S. Venture Capital Investment By Year
Year Number of Deals Total Investment (USD Mil)
2002 3,183 20,849.83
2003 3,004 18,613.83
2004 3,178 22,355.27
2005 3,262 22,945.71
2006 3,827 26,594.17
2007 4,124 30,826.31
2008 4,111 30,545.51
2009 3,065 19,745.81
2010 3,526 23,253.31
2011 3,673 28,425.08
Source: http://www.nvca.org/ffax.html

Institutional investors and wealthy individuals are often attracted to private-equity investments. This includes large university endowments, pension plans and family offices. Their money goes into pools that represent a source of funding for early-stage, high-risk ventures and plays a major role in the economy.

Often, the money will go into new companies believed to have significant growth possibilities in industries such as: telecommunications, software, hardware, healthcare and biotechnology. Private-equity firms try to add value to the companies they buy, with the goal of making them even more profitable. For example, they might bring in a new management team, add complementary companies, aggressively cut costs and then sell for big profits.

You probably recognize some of the companies below, which received private-equity funding over the years:

  • A&W Restaurants
  • Harrah's Entertainment Inc.
  • Cisco Systems
  • Intel
  • Network Solutions (the world's largest domain name registrar)
  • FedEx

Without private-equity money, these firms might not have grown into household names.

Past Returns
According to Thomson Financial and the National Venture Capital Association, private equity has had the following average annual returns ending June 30, 2006:

Thomson Financials' U.S. Private Equity Performance Index: Investment Horizon Performance through June 30, 2006:

Investment Type 1 Yr 3 Yr 5 Yr 10 Yr 20 Yr
Private Equity 22.50% 13.40% 3.60% 11.40% 14.20%
Nasdaq 5.60% 10.20% 0% 6.20% 11.70%
S&P 500 6.60% 9.20% 0.70% 6.60% 9.79%
Source: http://www.nvca.org/pdf/Q206Performancefinal.pdf

So how can you get in on this?

Typical Minimum Investment Requirement
Private-equity investing is not easily accessible for the average investor. Most private-equity firms typically look for investors who are willing to commit as much as $25 million. Although some firms have dropped their minimums to $250,000, this is still out of reach for most people.

Fund of Funds
A fund of funds holds the shares of many private partnerships that invest in private equities. It provides a way for firms to increase cost effectiveness and thereby reduce their minimum investment requirement. This can also mean greater diversification, since a fund of funds might invest in hundreds of companies representing many different phases of venture capital and industry sectors. In addition, because of its size and diversification, a fund of funds has the potential to offer less risk than you might experience with an individual private-equity investment.

The disadvantage is that there is an additional layer of fees paid to the fund of funds manager. Minimum investments can be in the $100,000 to $250,000 range, and the manager may not let you participate unless you have a net worth between $1.5 million to $5 million.

Private-Equity ETF
You can purchase shares of an exchange-traded fund (ETF) that tracks an index of publicly traded companies that invest in private equities. Since you are buying individual shares over the stock exchange, you don't have to worry about minimum investment requirements.

However, like a fund of funds, an ETF will add an extra layer of management expenses that you might not encounter with a direct, private-equity investment. Also, depending on your brokerage, each time you buy or sell shares, you might have to pay a brokerage fee. (Read more about ETFs in Introduction To Exchange-Traded Funds, 4 Ways To Use ETFs In Your Portfolio and The Benefits Of ETF Investing.)

Special-Purpose Acquisition Companies (SPAC)
You can also invest in publicly traded shell companies that make private-equity investments in undervalued private companies. But they can be risky. (Find out more about shell companies in Handcuffs And Smoking Guns: The Criminal Elements Of Wall Street, Putting Management Under The Microscope and The Ghouls And Monsters On Wall Street.)

The problem is that the SPACs might only invest in one company, which won't provide much diversification. They may also be under pressure to meet an investment deadline as outlined in their IPO statement. This could make them take on an investment without giving it thorough due diligence. (To learn more about SPACs, see Mergers And Aquisitions: Understanding Takeovers and The Basics Of Mergers And Acquisitions.)

The Bottom Line
There are several key risks in any type of private-equity investing. As mentioned earlier, the fees of private-equity investments that cater to smaller investors can be higher than you would normally expect with conventional investments, such as mutual funds. This could reduce returns. Additionally, as private-equity investing opens up to more people, the harder it could become for private-equity firms to locate good investment opportunities.

Plus, some of the private-equity investment vehicles that have lower minimum investment requirements do not have long histories for you to compare to other investments. You should also be prepared to commit your money for at least 10 years; otherwise, you may lose out as companies emerge from the acquisition phase, become profitable and are eventually sold.

Companies that specialize in certain industries can carry additional risks. For instance, many firms invest only in high-technology companies. Their risks can include:

  • Technology Risk - Will the technology work?
  • Market Risk - Will a new market develop for this technology?
  • Company Risk - Can management develop a successful strategy?

Despite its drawbacks, if you are willing to take a little more risk with 2 to 5% of your investment portfolio, the potential payoff of investing in private equity could be big.

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