If you are looking for ways to diversify your portfolio and invest in companies that are not publicly traded, you might be interested in private equity.
Private equity is a form of alternative investment that involves buying and managing private companies, either in whole or in part, to increase their value and sell them for a profit.
But what exactly is an alternative investment, and how does private equity fit into this category?
In this article, we will explain the basics of alternative investments, the pros and cons of private equity, and how you can access private equity funds through platforms like Schwab Alternative Investment Marketplace.
What Are Alternative Investments?
Alternative investments are any financial assets that do not fall into the conventional categories of stocks, bonds, and cash.
They typically have different risk-return profiles, lower liquidity, higher fees, and less regulation than traditional investments.
Some examples of alternative investments are:
- Hedge funds: Pooled investment funds that use various strategies to generate high returns, such as short selling, leverage, derivatives, and arbitrage.
- Venture capital: Investments in early-stage startups that have high growth potential but also a high risk of failure.
- Private equity: Investments in private companies that are not listed on stock exchanges, either by buying them outright or by acquiring a minority stake.
- Real estate: Investments in physical properties or property-based securities, such as real estate investment trusts (REITs), real estate mutual funds, or crowdfunding platforms.
- Commodities: Investments in raw materials or natural resources, such as gold, oil, corn, or coffee.
- Cryptocurrencies: Digital currencies that use encryption to secure transactions and control the creation of new units.
- Collectibles: Investments in rare or unique items, such as art, wine, cars, coins, or stamps.
Alternative investments can offer several benefits to investors who are looking for higher returns, lower correlation with the stock market, or exposure to niche sectors or markets.
However, they also come with some drawbacks, such as higher volatility, lower transparency, higher complexity, and limited access.
What Are the Benefits and Risks of Private Equity?
Private equity is one of the most popular and lucrative forms of alternative investments.
According to Preqin, a leading provider of data and insights on alternative assets, the global private equity industry had $4.5 trillion in assets under management as of June 2020.
The average net internal rate of return (IRR) for private equity funds was 15.8% as of December 20192, compared to 10.7% for the S&P 500 index over the same period.
Some of the benefits of private equity are:
- Higher returns: Private equity funds can generate higher returns than public markets by acquiring undervalued or distressed companies, improving their operations and profitability, and selling them at a premium.
- Lower volatility: Private equity funds are less affected by the fluctuations of the stock market, as they are not subject to daily price movements or quarterly earnings expectations.
- Long-term horizon: Private equity funds typically have a long-term investment horizon of 7 to 10 years4, which allows them to focus on the strategic growth and value creation of their portfolio companies.
- Active involvement: Private equity funds are active investors who often take a controlling stake in their portfolio companies and provide them with financial and operational support, expertise, and networks.
However, private equity also has some risks and challenges, such as:
- Higher risk: Private equity funds involve higher risk than public markets, as they often use leverage (debt) to finance their acquisitions, which increases their financial obligations and exposure to default. Moreover, private equity funds invest in companies that may have uncertain prospects or face competitive pressures.
- Lower liquidity: Private equity funds are illiquid investments that lock up investors’ capital for several years without any guarantee of return or exit. Investors cannot easily sell or redeem their shares in private equity funds before the end of their term.
- Higher fees: Private equity funds charge high fees to their investors, typically 2% of assets under management per year plus 20% of profits above a certain threshold (known as carried interest).
- Lower transparency: Private equity funds are less transparent than public markets, as they do not have to disclose their performance data or portfolio information to the public or regulators.
