There has been some hype over investing in private equity, which is an investment in a company before it makes an initial public offering, or IPO.
According to the management consulting firm McKinsey & Company, there is an argument to be made that private equity usually outperforms other investments. This might be true, although the metric McKinsey used is subject to some flaws. You can imagine that getting in on the ground floor of an up-and-coming company could be extremely profitable. Of course, untried companies fail all the time.
Another study by Bain & Company found that private equity did outperform public stocks – but not in the last decade. In the last 10 years, the returns have been approximately equal.
Moreover, big investors commonly put part of their highly diversified portfolios in private equity. And Vanguard, which typically represents smaller investors, published a white paper last year encouraging some investors to allocate part of their portfolios to private equity.
There are risks commensurate with the rewards
As we said, untried companies fail at a substantial rate. When they do, their private equity investors stand to lose their entire investment.
If you learn of a private equity deal, proposes one Forbes contributor, you should immediately question why you’re being made aware. Why hasn’t the company gone a more traditional route, such as seeking money from a large investor? Is it because the risks are greater than usual? Could getting money from smaller investors actually increase the risk?
These investments are also illiquid, meaning that you can’t easily retrieve your money in the short term. Your money will be locked in for a while. That’s fine for a patient investor with a long investment horizon, but many advisors have traditionally chosen less-volatile investments for the long haul. Does it meet your time horizon and risk tolerance?
Another thing to consider is the cost of private equity investing. One study found that the average management fee private equity managers charge is 1.5%, and you could also be on the hook for carried interest as high as 20% of all gains. Other small costs like audits, document processing and legal fees could bring your costs to as high as 11%.
Private equity may only be appropriate as part of a well-diversified portfolio
Private equity investments could, in theory, be a chance to see tremendous gains over time. They don’t necessarily follow the indexes, and you could read the cards right and get lucky.
Consider how diversified your current portfolio is. Does it contain a classic mix of short-, medium- and long-term investments? Does it contain some steady winners and some slightly riskier choices? If so, you might consider adding one or two private equity funds or even direct investments in companies in place of some of your riskier options. Don’t dip into your steady performers on a tip.
Direct investment into a pre-IPO company is inherently risky. It may not be an appropriate investment for you. Take the time to think about this type of investment carefully before you dive in. Examine all the information you can get your hands on. Don’t allow yourself to be rushed into a decision. If it’s an investment that must be rushed, the smaller investor should seriously consider letting it pass.