High-net-worth investors have embraced the strategy of placing a portion of their equity positions in alternative assets classes, including private equity investments. Private equity money is invested in new companies or start-ups that have significant growth potential. Privateequity firms also try to turn around or improve the companies they invest in by changing the management team or streamlining business operations.
Private equity investing has gained traction due to its history of high returns, which is not easily achieved through 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.
Key Takeaways
- Private equity money by wealthy clients is invested in new companies or startups that have significant growth potential.
- Privateequity investing often have high investment minimums, which can magnify gains but also magnify losses.
- Liquidity risk exists since private equity investors are expected to invest their funds with the firm for several years on average.
- Market risk is prevalent since many of the companies invested in are unproven, which can lead to losses if they fail to live up to the hype.
Understanding Private Equity Risk
Private equity firms pool investor money with other sources of borrowed financing to acquire equity ownership positions in small companies with high growth potential. The investors are typically wealthy individuals and institutional investors, which are companies that invest money on behalf of their clients. Institutional investors can include pensions, mutual funds, and insurance companies.
Privateequity firms attempt to improve the companies they invest in by replacing the management team and board of directors. The firms also engage in cost cutting, adding products and services, as well as selling part of the companies in a spinoff to raise funds. All of the actions of the firm are to increase the return on investment for the private equity investors involved.
Private equity firms are involved in several industries, including:
- Technology, such astelecommunications, software, and hardware
- Healthcare, including drug companies
- Biotechnology, which utilizes living organisms to help produce health-related products, biofuels, and food production.
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.
Investment Minimum
Privateequity investing has a high barrier to entry, meaning it requires an enormous amount of capital for a minimum investment, which can be as much as $25 million. There are some private equity firms that cater to a lower threshold with investment minimums of $250,000, but they are still higher than most traditional investment minimums. As a result of the large amounts committed, private equity investors stand to gain substantially on even a small percentage gain from their investment. However, investing can be a double-edged sword, meaning that those large sums of money can equally lead to significant losses from a negative return on investment.
Liquidity Risk
Liquidity risk is a concern for investors in private equity. Liquidity measures the ease at which investors can get in or out of investments. Earnings growth for small companies can take time, which is why 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 stocks, mutual funds, or exchange-traded funds (ETFs), investors can sell an investment on the same day if needed. However, private equity investments do not offer that luxury.
Market Risk
Private equity investors also face greater market risk with their investments compared to traditional investments since there's 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. An ineffective management team, a new product launch that fails, or a new, promising technology that becomes obsolete due to competitors, can lead to significant losses for private equity investors.
Although other asset classes carry market risk, default risk is lower with more established companies. Also, private equity investments may involve the company using a significant amount of debt, which can be costly to service through interest payments over time.
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.
FAQs
Although other asset classes carry market risk, default risk is lower with more established companies. Also, private equity investments may involve the company using a significant amount of debt, which can be costly to service through interest payments over time.
What are the risks of investing in private equity funds? ›
Such risks may include but are not limited to (i) multiple levels of expense; and (ii) reliance on third-party management. In addition, private equity funds may issue capital calls, and failure to meet the capital calls can result in consequences including, but not limited to, a total loss of investment.
How is private equity different from other investments? ›
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.
Which type of risk is most associated with equity investment? ›
What risks are associated with equity investments?
- Credit risk: a company could be unable to pay its debt.
- Foreign currency risk: a company's value could change because of shifts in the value of different international currencies.
- Liquidity risk: a company could be unable to meet its short-term debt obligations.
Public investors build wealth by accumulating stocks. By contrast, private equity investors get paid through distributions. Since investors who invest in public stocks can easily trade shares on public exchanges, they have the advantage of liquidity over private equity investment.
Is private equity less risky than public equity? ›
Public equity refers to ownership in publicly traded companies, which are available to anyone with an investment account. Private equity has historically higher returns but isn't available to everyone and has downsides that include higher risk, higher fees, and lower liquidity.
What is the downside of private equity investment? ›
Higher risk: Private equity investments often involve significant risks, including the potential loss of your entire investment, which must be part of the individual investors' consideration process.
Why do investors prefer private equity? ›
Low correlation to other asset classes: In terms of performance, Private Equity funds are less volatile than listed markets. Diversification: You can diversify away from more traditional asset classes.
What are the advantages and disadvantages of investing in a private equity fund? ›
Investments in PE may have a longer time horizon, as exits can take several years. PE investments may involve a higher level of risk due to the nature of private equity markets. PE Investors may benefit from potential higher returns, but the illiquidity of investments can be a consideration.
Why is private equity a good investment? ›
Since private equity funds have far more control in the companies that they invest in, they can make more active decisions to react to market cycles, whether approaching a boom period or a recession. The result is that private equity funds are more likely to weather downturns.
Liquidity risk: The illiquidity of private equity partnership interests exposes investors to asset liquidity risk associated with selling in the secondary market at a discount on the reported NAV. Market risk: The fluctuation of the market has an impact on the value of the investments held in the portfolio.
Which of the investment types carries the highest risk Why? ›
Over many decades, the investment that has provided the highest average rate of return has been stocks. But there are no guarantees of profits when you buy stock, which makes stock one of the most risky investments.
What investment has the lowest risk? ›
Safe assets such as U.S. Treasury securities, high-yield savings accounts, money market funds, and certain types of bonds and annuities offer a lower risk investment option for those prioritizing capital preservation and steady, albeit generally lower, returns.
Why is private equity better than investment banking? ›
However, investment bankers tend to work longer hours, often working late into the night and on weekends. Private equity firms also tend to have a more relaxed work environment and offer more flexible hours. So, if you're looking for a career with less hours commitment, private equity may be the way to go.
Why does private equity outperform public markets? ›
Arbitrage. The relatively unpredictable pricing that defines private markets creates opportunities for investors to leverage advantages like economies of scale, expertise, and other asset holdings.
How do the private equity investment strategies differ from hedge fund strategies? ›
Investment Focus: Hedge funds typically invest in publicly traded assets using various strategies to achieve returns, while private equity funds invest in private companies or buyouts with a focus on long-term value creation.
Is it good to invest in private equity fund? ›
Since private equity funds have far more control in the companies that they invest in, they can make more active decisions to react to market cycles, whether approaching a boom period or a recession. The result is that private equity funds are more likely to weather downturns.
Are private equity funds a good investment? ›
Private equity is an attractive investment option for high-net-worth individuals and institutional investors because of its potential for high returns. Private equity falls under the category of alternative asset classes.
Which is riskier private equity or hedge fund? ›
Both offset their high-risk investments with safer investments, but hedge funds tend to be riskier as they focus on earning high returns on short time frame investments. It is hard to make a generalization on the level of risk, as individual funds vary so much based on their investing strategies.
