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.
Why invest in private equity?
As you can see from the chart below, private equity is on the upswing:
| U.S. Venture Capital Investment By Year |
| Year |
Number of Deals |
Total Investment (USD Mil) |
| 1996 |
2,469 |
10,762.30 |
| 1997 |
3,080 |
14,591.99 |
| 1998 |
3,550 |
20,718.89 |
| 1999 |
5,396 |
53,487.98 |
| 2000 |
7,812 |
104,379.88 |
| 2001 |
4,451 |
40,537.78 |
| 2002 |
3,053 |
21,692.88 |
| 2003 |
2,876 |
19,613.81 |
| 2004 |
2,991 |
21,768.86 |
| 2005 |
3,027 |
22,261.59 |
| 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 ReturnsAccording 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:
So how can you get in on this?
Typical Minimum Investment RequirementPrivate-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 FundsA
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. (To learn more about fund of funds, see
Life-Cycle Funds: Can It Get Any Simpler?,
Advantages Of Mutual Funds and
The Dangers of Over-Diversification.)
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 ETFYou 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,
How To Use ETFs In Your Portfolio and
Advantages Of Exchange-Traded Funds.)
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
The Wacky World of M&As and
The Basics Of Mergers And Acquisitions.)
Is it worth it?
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 2-5% of your investment portfolio, the potential payoff of investing in private equity could be big.
by George D. Lambert, (Contact Author | Biography)
George D. Lambert is a freelance financial writer with more than 20 years of experience in the financial services industry. He has worked as a Certified Financial Planner, a Certified Divorce Financial Analyst and an arbitrator for the NASD, NYSE and AAA. George is approved by the Florida Licensing Education Section to instruct life, health and variable annuity courses. To read more about George and his services, visit www.e-financialWriter.com. Also be sure to check out his latest book, "A Boomer's Guide To Long-Term Care".
If you have questions about George's articles, please check his blog (http://e-financialwriter.blogspot.com/) before emailing him.
