Private Equity is a type of investment. Private Equity investments are those investments in companies that are not publicly-traded. (Publicly-traded entities are those whose shares of ownership are available on a public exchange. Apple Inc. (ticker: AAPL) is an example of a publicly-traded company, traded on NASDAQ.)
Private Equity investors usually make their money once a company goes public – once the formerly private company launches its initial public offering (IPO). Facebook (ticker: FB) and Twitter (ticker: TWTR) are examples of recent IPOs. Private Equity can also involve a number of important strategies (such as leveraged buyouts and recapitalization) using companies that do trade on the market.
[subtitle3]Challenges of Private Equity[/subtitle3]
Data has shown that hedge fund-style strategies, Private Equity among them, often struggle to produce superior risk-adjusted investment returns relative to more conventional investments. Private Equity’s lackluster investment returns may stem from:
1. High Fees – While Private Equity may deliver high returns, it usually has high fees. This is the conundrum of any actively-managed investment – private equity included. Studies have shown that usually the actively-managed, high-fee strategy under performs the strategy utilizing less expensive management (passive strategy).
2. Unproven Low Correlation – An argument in favor of Private Equity is the low correlation of investment returns from that of the publicly-traded market. That is, while S&P 500 goes down, private equity investments theoretically go up, or sideways. In practice, this has not been the case. Ivy League endowments, who invest billions into private equity, suffered during the recent financial crisis where private equity – as well as other alternative investments – declined with the market.
3. Illiquidity – Private Equity investments are illiquid. As opposed to publicly-traded investments – which can be sold at their market price within seconds, an investment in private equity cannot. Holdings periods for Private Equity may usually last several years.
[subtitle3]The Fourth Challenge of Private Equity[/subtitle3]
A recent report by Preqin shows a new challenge of Private Equity. A Wall Street Journal contributor noted:
Private Equity has raised more than it can spend.
~ Andrew Blackman
Of the $3.5 billion invested in Private Equity, over $1 billion of that is currently sitting in cash. As with any investment pool, cash pulls down investment return. The reason for this massive, uninvested cash allocation is a lack of investment opportunities. Blackman’s article notes that this is, in part, because valuations are high.
In short, private equity is becoming a less attractive investment. In addition to the challenges of:
1. High Fees
2. High Correlation to the Broad Market
Private Equity now has the additional hurdle of diminishing investment opportunities. For this reason, individuals may wish to consult with a fee-only investment professional before electing to invest in Private Equity, or any alternative investments.
Blackman, A. (2014, June 15). Private Equity Has More Than It Can Spend. Retrieved from The Wall Street Journal: http://online.wsj.com/articles/private-equity-has-more-than-it-can-spend-1402670650
Ibbotson, R. G., & Kaplan, P. D. (2000, January/February). Does Asset Allocation Policy Explain 40, 90 ro 100 Percent of Performance?
Preqin. (2014). 2014 Preqin Global Private Equity Report (Sample). New York, New York: Preqin. Retrieved from https://www.preqin.com/docs/samples/The_2014_Preqin_Global_Private_Equity_Report_Sample_Pages.pdf
Swensen, D. F. (2005). Unconventional Success: A Fundamental Approach to Personal Investment. New York, NY: Free Press