Private Equity Explained and How To Invest as An Individual

If you have extra money lying around that you want to invest, how do you decide where to put it? What’s your process for choosing a particular fund, company, or person to invest your hard-earned money? If you’re a business owner how do you go about financing to raise capital for expansion?

In today’s world, investing has never been easier. It is very simple and low-cost to open an account and invest money directly into the stock market. Discount brokerage firms, such as Schwab and TD-Ameritrade, have made it easier for the individual investor to get into the market and build a portfolio or day trade stocks to their heart’s content. This is both good and bad in my opinion.

On the one hand, you have access to literally every publicly traded company and fund on the market. To build a portfolio and invest in stocks and bonds is very cheap and easy to do. However, is it the prudent thing to do for the average investor? The ones who are well-read, know finance and tax, and are disciplined can pull it off to an extent. That said, it’s a full-time job to stay informed on the changes in the investment industry and tax law.

There are countless funds and new investment vehicles being brought to the market each year. If you’re not paying attention, you may be missing out on private equity opportunities for your portfolio.

What is Private Equity?

Private equity (PE) firms typically consist of large pools of money that invest in private companies. A PE firm may have multiple funds with different investment objectives.

This means they may be investing in certain industries such as tech or manufacturing, and have different time horizons for the funds. The companies these funds invest in are private and therefore are not listed on exchanges. This can come with both advantages and disadvantages which will be discussed later.

A lot of people have worked in private equity or used it for funding, particularly if they are a founder or business owner of a certain size. But, if you’re an individual investor, how familiar are you with it, and does it make sense for your portfolio? Does it make sense as a source of financing as a business owner?

An example of a private company could be a mom and pop venture such as a hardware store or bakery. Let’s say the hardware store begins to grow and they start opening up multiple locations in their city. Then they start to expand throughout their region by opening locations in multiple states. Then they want to expand nationally.

At this point, the hardware store might need capital to grow so they start looking for funding. You can raise capital either through debt financing or equity financing.

Equity financing can be done without having to go public. This can be accomplished by selling shares and giving ownership to institutions or individual investors privately.

Who Can Invest in Private Equity

Private equity firms usually require higher minimum investments than the usual mutual fund. This can be anywhere from $250,000 to $1 million and above.

Accredited investors and large institutions are commonly the ones who invest in private equity. On the accredited investor side this would be high net worth and ultra high net worth individuals. There can be many different types of financial institutions such as endowments, banks, and pension funds.

The Definition of An Accredited Investor

An accredited investor is defined by the SEC under Rule 501 of Regulation D as:

An accredited investor, in the context of a natural person, includes anyone who:

earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, OR
has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence).

There are other categories of accredited investors, including the following, which may be relevant to you:

any trust, with total assets in excess of $5 million, not formed specifically to purchase the subject securities, whose purchase is directed by a sophisticated person, or
any entity in which all of the equity owners are accredited investors.

The full rules can be read here on the SEC’s website, also referred to as the electronic code of federal regulations. This is where you can access SEC rules and regulations if you are so inclined and need some bedtime reading.

How to Invest in Private Equity

You can invest in private equity by going through a firm or fund as previously discussed. Some of the more popular names are Blackstone, The Carlyle Group, and KKR.

You can see a list of the largest private equity firms through Private Equity International’s database. These companies produce funds to make available for investment. Oftentimes, there will be time limits as to when you can invest in a fund as they will close to investors after certain asset minimums are met.

Advantages of Private Equity

From the perspective of a business, a major advantage of taking private equity investment is to avoid more burdensome regulatory compliance and oversight. This is opposed to going public and having to register with the SEC, plus added cost and pressure from more shareholders.

Going public requires more information to be made available to the public. It can be very expensive to manage the regulatory compliance and disclosures that must be maintained.

Private equity investment can be an easier avenue to raise capital as there are not as many regulatory restrictions a dealing with a bank to get approved for a loan or registering with the SEC. Many times you will be working with a PE firm, an individual, angel investor, or a venture capitalist. These can be much more relationship-driven with fewer people involved.

From an individual investor perspective, private equity can be an alternative asset class to add to your overall portfolio. This could help with diversification and provide you with access to non-publicly traded companies in hopes to achieve a greater return on investment.

Disadvantages of Private Equity

As an individual investor, the risk profile is ramped up significantly since you’re usually dealing with smaller start-up style or middle-market companies. It could go very well or very badly. That’s why it makes sense to invest in a fund that has many different companies to help you manage individual company risk. The time horizon and investment objectives need to be considered as well. Determine how these components fit into your financial situation.

A lack of liquidity is common for these funds. They can close the funds for investment and allow distributions for a certain amount of time, such as 5 to 10 years. This is because they can invest funds as needed in a volatile market and do not have to meet shareholder liquidation requests in such an event. This can help them stay invested during a downturn.

As a business owner, you are dealing with owners who will expect to see results. Things can get much more complicated when raising money and getting more people involved. It sounds good in theory but the grass isn’t always greener.

If you’re looking for capital ask, yourself why you need the money and have a clear cut plan on what you will do with it. Be willing to give up control and be subjected to outside influences.

Conclusion

Private equity can be a great way to raise capital for your company. It can also be a great way to invest your money as an individual.

As with most things in life, there is no free lunch. You need to understand your goal for your business or portfolio as well as the risks involved. Thorough research and due diligence should be done when you are considering raising funds or investing with a particular company.

If you’d like an objective second opinion about your finances, please contact Michael Shea, a CERTIFIED FINANCIAL PLANNER, at Applied Capital. Email him at [email protected] or fill out a contact form.

DISCLAIMER
This blog is provided for informational purposes only. Such views are subject to change at any point without notice. The information in the blog should not be considered investment or tax advice or a recommendation to buy or sell any types of securities. Some of our blogs or information therein have been obtained from third party sources believed to be reliable but such information is not guaranteed. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. No reliance should be placed on, and no guarantee should be assumed from, any such statements or forecasts when making any investment decision.

Subscribe To Our Newsletter!