For high-net-worth individuals and institutional investors, private equity is an attractive investment option because of its potential for high returns. Private equity falls under the category of alternative asset class, and although its definition is muddled, it most commonly refers to a managed pool of raised or borrowed funds explicitly used for obtaining an equity ownership position in smaller companies with growth potential. Private equity firms encourage investment from wealthy sources by boasting greater return on investment than other alternative asset classes or more conventional investment options.
Cambridge Associates, the index that tracks the performance of private equity firms within the United States, provided investors an annualized return of 16% from 2003 through 2013. Over the same time frame, the Russell 2000 Index, a performance tracking metric for small companies, returned an annualized 9.1% to investors, while the S&P 500 returned 7.4%. It is clear that an investor taking a risk with private equity investment would have received a much higher return than those who chose the more conventional route of investing in an ETF that tracked a popular index.
When compared to other alternative investments, however, private equity returns are less impressive. Through the third quarter of 2013, Cambridge Associates reported similar performance for private equity and venture capital investments over the last decade, with private equity inching ahead in most periods. However, the venture capital index returned an annualized 26.1% over the last 15 years, while private equity returned an annualized 12%. Over the last 20 years, venture capital comes out ahead with a 30% annualized return compared to private equity at 13.5%.
Although private equity can be a lucrative investment option for high-net-worth individuals, it is not the only alternative asset class that provides attractive returns. Investors interested in private equity, venture capital or other alternatives should be aware the potential for high returns also comes with a high degree of risk; it is recommended they assess their tolerance for risk prior to investing.