Should your portfolio include private equity? Absolutely not. I know I’m going to receive some flak for that answer, so allow me to explain. (For more, see: What Is Private Equity?)

Let's begin with valuation and liquidity. If there is nowhere to sell, how do you value your investment? (For more, see: Valuing Private Companies.) That’s a scary scenario, but those who believe in private equity — and there are plenty of them — will point out that private equity has been outperforming public equity. This is, quite simply, because private equity tends to outperform public equity during good times. If the investment market as a whole makes a turn for the worse, private equity will be punished more than public equity. (For more, see: Difference Between Private and Public Equity.)

Some of these angel investors are chasing multi-baggers with a minimum $5,000 investment. A lot of people will invest more. In most cases, you need to be an accredited investor, which means two years of $200,000 in income and a minimum net worth of $1 million. The bad news is that the majority of these investors are likely underwater at the moment. They’re all chasing the next Facebook Inc. (FB), failing to realize that there is only one Facebook. Currently, there are approximately 225,000 angel investors in the United States. This is an extremely crowded space, which is never a good sign. But that’s not the worst part. (For more, see: Can I Become An Angel Investor?)

Illiquidity

Remember, private equity is illiquid. This could be seen as a positive because it takes emotion out of the equation — investors won’t sell at the wrong times due to negative news that eventually will be seen as a short-term hiccup. But illiquidity holds more risk than rewards. Most private equity investors must wait five to eight years to see a potential return, and a return is rare because most companies fail. All that money is locked up across some 225,000 investors. When people begin to realize that the market is oversaturated, private equity will fail, and unlike public equity, there will be no way out. (For more, see: What Private Equity Investments Are Out There?)

If you’re not looking to invest in private equity right now but perhaps in the future, there are some advantages:

  • Illiquid. Yes, this is also a disadvantage, but eliminating the temptation to sell based on emotion can be a big positive.
  • Potential. Investing in private equity allows you to get in on the ground floor (as in prior to an initial public offering). Imagine having invested in Facebook in its early stages.
  • Fundamentals. Unlike public equity, there is no speculation trading; everything is based on fundamentals.
  • Tax advantages.

The advantages end there. In addition to illiquidity, the biggest disadvantages are a wide bid-ask spread, no access to information unless you’re close with the right people, no regulation, often overstated internal rate of return figures and management trying to raise capital at times that aren’t timely for you. (For more, see: Learn the Lingo of Private Equity Investing.)

There are such things as liquid alternatives, which invest in a variety of assets — including private equity — via mutual funds or exchange-traded funds, but these often are more expensive or less liquid compared to public equity or traditional funds. (For more, see: Investing in Alternative Mutual Funds and ETFs.)

How to Succeed 

The only way to succeed in private equity is through diversification. Choose a category you know well (distressed investments, real estate, oil and gas, venture capital, etc.) and invest in the companies that you think have the most potential. If you’re correct on just one, it can offset the losing investments. In high-risk situations, be sure that the expected return is higher. You need to be rewarded for taking on that extra risk. (For related reading, see: Are Your Investments Taking on Unnecessary Risk?)

The Bottom Line

You can invest directly, via a private equity fund or through crowdfunding. However, this is irrelevant for those who are really paying attention to current market conditions. Not only is investing in private equity more challenging than investing in public equity, but the private equity market is in extreme bubble territory. This probably isn’t what many people want to read, but capital preservation is just as important as potential returns. (For more, see: Private Equity a Trendsetter for Stocks.)

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