High-net-worth investors have embraced the strategy of placing a portion of their equity positions in alternative assets classes, including private equity investments. This method of diversification has gained traction due to its history of high returns not easily achieved in more conventional investment options. However, private equity carries a different degree of risk than other asset classes due to the nature of the underlying investments.
Private equity firms pool investor money with other sources of borrowed financing to acquire equity ownership positions in small companies with high growth potential. Although this may seem like a smart investment strategy, there are a number of different risks associated with investing in small growth businesses, especially those that are still in their startup phases.
Liquidity risk is a concern for investors in private equity; growth in small companies can take time, and private equity investors are expected to leave their funds with the private equity firm between four and seven years on average. Some investments require even longer holding periods before any returns are experienced. In other asset classes, such as individual company stock, mutual funds or exchange-traded funds (ETFs), investors can sell off an investment in a matter of days should an it rapidly decline. Private equity does not offer that luxury.
Private equity investors also face greater market risk with their investments, as there is no guarantee that any of the small companies in which private equity firms invest will grow at all. Failure is much more common among these companies, with only one or two out of a dozen making any significant return for the firm and its investors. Although other asset classes carry market risk, the concern for default is less with more established companies and their debt or equity issues.
Overall, the risk profile of private equity investment is higher than that of other asset classes, but the returns have the potential to be notably higher. For investors with the funds and the risk tolerance, private equity can be a lucrative investment for a portion of a portfolio.