Keeping It Private
by Frederick R. MacLean

“Pay no attention to that man behind the curtain! The greatest Oz has spoken!”

– The Wizard of Oz

The Wizard of Oz was said to have magical powers, but he was arrogant and inaccessible when it came to solving people’s problems. Ultimately, he was able to help Dorothy and her friends, but his powers were far more mundane than he originally implied.

The investment world is full of elusive individuals who claim to be wizards; among the most intriguing is the private equity manager. Like the Wizard of Oz, a private equity manager can serve as a valuable guide for those seeking to invest in the complicated, high-risk world of private equity. However, like the Wizard, their powers are probably less magical than they claim.

The equities most people are familiar with are “public” equities such as Amazon or Microsoft, which are registered with federal regulators and traded on various exchanges throughout the day. Private equity (PE), on the other hand, refers to an ownership interest in a company that does not trade on a public exchange. For example, if you own a small business or if you are a partner in a professional company such as a medical practice, law firm, or accounting firm, you already own PE.

In the context of investing, however, most individuals access PE by purchasing an interest in a professionally managed PE fund. Like a mutual fund, a PE fund typically manages a diversified portfolio of private companies that are selected by the fund manager according to a predetermined set of criteria. However, traditional PE funds differ from mutual funds and exchange-traded funds (ETFs) in many important ways:

Fees — PE funds typically charge a 1%-2% management fee plus a 10%-20% fee on profits, whereas the fees on the average US equity mutual fund are a mere 0.6%, according to Vanguard.
Liquidity — PE funds usually have a shelf life of 10 to 12 years, during which the invested capital is gradually returned to the investors at the discretion of the fund manager. In the intervening years, the fund offers limited liquidity for the invested capital, so the fund manager largely determines when investors can have access to their money.
Complexity — PE investors should expect higher accounting bills and delayed tax filings because most PE funds are required to report taxable income and capital gains according to partnership tax rules.
Accessibility — PE funds tend to have high minimum investment thresholds (often $1 million or more), and they are restricted to investors who meet specified income and net worth requirements.

With all those drawbacks, why would anyone want to invest in private equity? The answer is simple: higher expected returns. Wealthy individuals and large institutional investors typically own PE either directly or through a PE fund manager, in an attempt to boost their portfolio returns.

According to StepStone Group, the top-performing quartile of PE funds has performed better historically than the top-performing quartile of equity mutual funds, so there may be significant reward for all the baggage that comes with PE investing. However, the worst-performing PE funds also tend to underperform the worst-performing mutual funds, so the risk inherent in choosing the wrong fund is higher in the world of PE.

Aside from the potential for outperformance, PE offers diversification away from public markets, and because they typically only report prices on a quarterly basis, PE funds are not subject to the gut-wrenching noise of daily price swings inherent in public stock markets.

But for some people, the most enticing aspect of PE is its perceived exclusivity. Anyone can buy a retail mutual fund of public equities, and some new products are on the way that make PE more accessible to individual investors. But most PE funds are sold by invitation only. PE funds have high minimum investment and net worth requirements as well as strict caps on the size of the funds, and they often limit the number of investors accepted into a particular fund. That makes PE investments fun to talk about at cocktail parties.

So, should you invest in private equity? The data shows that the investment returns from private markets may or may not prove to be higher than those of public markets, but the higher fees, lower liquidity, and additional complexity of private markets are a certainty. But if you are OK with the drawbacks and you are looking for a risky investment with the potential to win big, it makes sense to consider investing a small portion of your wealth in PE. Just make sure you move forward with caution and use an advisor: the level of complexity is higher and the range of potential outcomes is wider with PE than with public markets.

Even after the hype was stripped away and his true nature revealed, the Wizard of Oz was helpful to those who sought him out, but in a far more subdued way. In a similar vein, PE is not magic, but it does offer a valuable strategy that could be highly rewarding. So if you have some courage, brains, and a strong heart, you may want to give PE a closer look.