Looking for a way to “beat the market” in 2024 and beyond? If so, you’ve probably heard about the market-beating potential of private equity investments. The most recent U.S. Private Equity Index from Cambridge Associates reports an average return of about 15% from June 2003 to June 2023, compared to 10% on the Russell 3000 Index. However, before diving into private equity investing, everyday investors should be aware of a few important considerations.
For almost 100 years, the world of private equity was largely “off limits” to Main Street investors. Legally speaking, only accredited investors were allowed to invest in private equity offerings.
But thanks to the Jumpstart Our Business Startups (JOBS) Act — and an influx of new publicly listed private equity offerings — everyday investors are seeing a Cambrian explosion in access to private equity opportunities.
How Private Equity Investing Has Changed in Recent Years
It is worth noting that private investments such as private equity, hedge funds, and venture capital funds typically require individual investors to be accredited: they must have an income of more than $200,000 for an individual and $300,000 if married and filing jointly for two years prior to investing, or a net worth of $1 million, excluding a primary residence.
In the early ’80s, only 1%-2% of households were considered accredited. However, because the financial thresholds to become an accredited investor have not been indexed to inflation, more than 13% of all American households now qualify.
Despite this growing number of eligible households, private equity still operates like a private club. To get access to opportunities, you probably need to be a client of a name-brand financial institution. That’s not to mention the administrative challenges like 200-page subscription documents, underwriting, and complicated terms most people don’t understand.
With that said, the biggest innovation in private equity has been the JOBS Act of 2012. Thanks to this landmark piece of legislation, two important things happened.
The first was lifting the ban on “general solicitation” and advertising for specific types of private market deals. Before this ban was lifted, the only way to get into a private deal was to “know a guy,” as it was otherwise illegal for them to advertise the opportunity. However, those offerings — called Rule 506(c) of Regulation D — were still restricted to accredited investors only.
Then, in 2016 Title III of the JOBS Act went into effect, introducing a new framework that allowed both accredited and nonaccredited investors to invest in private market deals. More commonly known as Regulation Crowdfunding, this framework created a new pathway for companies seeking investments to raise capital from anyone over the age of 18, regardless of income or net worth.
There’s no doubt the JOBS Act transformed investment banking and capital markets as we know it. but the looser regulatory and disclosure requirements carry risks and may open the door for increased fraud.
The Biggest Risks of Private Equity Investing
One of the most common questions asked by people considering private equity is some version of, “How much can I make?” and “How fast can I make it?” While there is a potential to make significant returns in a short period, there is also plenty of risk that comes with it.
Outright fraud is always a concern when it comes to early-stage investing. But outside of that, the key risks are the same fundamental risks that are present in any investment:
Valuation Risk: Are you investing at a good price? If the goal is to make money as an investor, you don’t want to hurt your chances by overpaying.
Execution Risk: Can the management team execute on the business plan they’ve presented? If not, the returns likely won’t be what you expect.
Market Risk: Could forces outside of the management team’s control damage the company? It happens all the time, and that’s just part of the risks you’re signing up for as an investor.
However, most retail investors cannot accurately evaluate these risks and, therefore, have difficulty understanding the exact risks they are taking at the price and terms being offered.
What Are the Tax Implications?
Unless you’re investing into a fund structure — or otherwise receiving income reporting on a K-1 or 1099 — there really are no tax implications outside of normal due course. If you’re investing in private credit or cash-flowing real estate deals, taxes will be a consideration. Otherwise, for most private equity plays, it’s a three- to five-year hold, at least.
The only time you would incur tax liability would be on the asset’s sale (or disposal). This means you would be taxed at the long-term capital gains rate, just like any other investment you’ve held for more than 12 months.
5 Strategies for Investing in Private Equity as an Everyday Investor
With all the nuances, it can be difficult to navigate private equity investing. Here are five steps for everyday investors to incorporate private equity investments into their portfolios while balancing risk with potential returns:
1. Develop a comprehensive financial plan.
Before making any investment decisions, it’s crucial to have a well-defined financial plan that aligns with your personal financial goals. This plan should encompass budget management, cash flow, expenses, and essential recordkeeping, as these factors contribute significantly to achieving financial objectives.
2. Create an Investment Policy Statement.
Establish an investment policy statement — a written document that outlines your portfolio allocation, target returns, and rules for rebalancing. It’s essential to base your investment strategy on reasonable forecasted returns, typically in the 6%-10% per year range. Avoid the temptation to pursue excessively high returns, as this can lead to taking on unnecessary risk.
3. Focus on Downside Protection and Liquidity.
For retail investors managing their money, prioritize downside protection and liquidity, especially in the current late-stage market environment. While taking calculated risks is important, ensure that you can hold quality positions through market downturns and avoid being forced to sell assets at a discount due to short-term cash flow needs.
4. Seek Professional Advice.
Consider getting help from financial advisors or managers who can provide valuable insights and guidance. While there may be concerns about management fees, a competent manager can offer peace of mind and is often worth the cost. However, having a fundamental understanding of money and investing is essential to managing your financial advisor relationship effectively.
5. Educate Yourself.
Invest in your financial education by staying informed about investment strategies and financial planning concepts. Resources such as investor education newsletters can provide valuable insights into various financial planning concepts experienced investors use, making them more accessible to everyday investors.
Private equity was once out of reach for the average person, locked away behind the velvet ropes of an exclusive club. Education and due diligence can help balance the risks of private equity investing with the potential to experience significant portfolio gains. Just be sure you only invest what you can afford to lose and perform thorough research to make the smartest decisions possible.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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