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.
How risky are private equity investments? ›
When a private equity fund invests heavily in a single industry, it becomes highly susceptible to industry-specific risks. For example, if a fund primarily targets technology startups, it faces the risk that a downturn in the tech sector could adversely affect all of its portfolio companies simultaneously.
Is private equity more risky than public equity? ›
In many ways, private equity funds carry more risk than public equities due to the leverage, lack of liquidity, and very long lockup periods associated with such holdings.
Which type of investment has the greatest risk? ›
While the product names and descriptions can often change, examples of high-risk investments include:
- Cryptoassets (also known as cryptos)
- Mini-bonds (sometimes called high interest return bonds)
- Land banking.
- Contracts for Difference (CFDs)
Unlike public markets, where investors can regularly buy or sell their holdings, traditional private equity has lockup periods that can last for years.
What is the downside risk of private equity? ›
Private equity 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.
What is the main disadvantage of private equity investment? ›
However, private equity also comes with notable drawbacks. These investments typically require a long-term commitment, often locking up capital for several years, and they tend to be less liquid than public equities.
What is the problem with private equity? ›
Private equity funds are illiquid and are risky because of their high use of debt; furthermore, once investors have turned their money over to the fund, they have no say in how it's managed. In compensation for these terms, investors should expect a high rate of return.
Does private equity outperform the S&P 500? ›
As the chart shows, private equity funds have outperformed the S&P 500 over the long-term. In exchange for these compelling returns private equity investors give up the level of liquidity and transparency inherent to public markets.
Is venture capital riskier than private equity? ›
Level of risk: VC investments are considered riskier than private equity investments because start-ups without a profitability track record are more likely to fail. Private equity firms usually seek out companies that were once profitable and need to be turned around.
5 Best High-Risk Investments
- Initial public offerings (IPOs)
- Venture capital.
- Real estate investment trusts (REITs)
- Foreign currencies.
- Penny stocks.
But generally, cash and government bonds—particularly U.S. Treasury securities—are often considered among the safest investment options available. This is because there is minimal risk of loss. That said, it's important to note that no investment is entirely risk-free.
Which investment presents the most risk? ›
Equities and equity-based investments such as mutual funds, index funds and exchange-traded funds (ETFs) are risky, with prices that fluctuate on the open market each day.
What is private equity risk? ›
Private equity investments offer substantial opportunities for growth and returns, but they are not without risks. Investors in private equity face various types of risk, including market risk, liquidity risk, and operational risk.
How does private equity investing compare with public market investing? ›
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 makes private equity different? ›
Private equity investors believe that the benefits outweigh the challenges not present in publicly traded assets—such as complexity of structure, capital calls (and the need to hold liquidity to meet them), illiquidity, higher betas than the market, high volatility of returns (the standard deviation of private equity ...
What is the success rate of private equity investments? ›
Key Takeaways. Private equity produced average annual returns of 10.48% over the 20-year period ending on June 30, 2020. From 2000 to 2020, private equity outperformed the Russell 2000, the S&P 500, and venture capital. When compared over other time frames, however, private equity returns can be less impressive.
How many private equity investments fail? ›
Sector focus
Portfolio companies of private equity and venture capital firms accounted for more than 16% of all US bankruptcy filings in 2023, their largest share of the annual bankruptcy rate going back to at least 2010, Market Intelligence data shows.
Is investing in private equity a good idea? ›
Diversification: Private equity investments can benefit a portfolio as they are typically not correlated with traditional investments. By adding private equity to a portfolio, investors can reduce their overall portfolio risk and potentially enhance returns.
What are the problems with private equity investments? ›
Private equity funds are illiquid and are risky because of their high use of debt; furthermore, once investors have turned their money over to the fund, they have no say in how it's managed. In compensation for these terms, investors should expect a high rate of return.
