As a Kiplinger reader, it’s probably safe to say making smart decisions with your money is important to you. So as an investor, how do you find the right balance between risk and reward? What strategy can you implement that not only helps safeguard your wealth but also helps it grow?
The ever-evolving and changing financial landscape can be challenging. However, it does allow an opportunity to evaluate different investments. Publicly traded investments have dominated the investment landscape for centuries. In recent years, private equity (PE) has emerged as a valuable investment alternative to public markets. PE can offer a range of benefits that public markets simply cannot match. This article will explore reasons why incorporating private equity into your investment portfolio could be a smart, strategic move for building wealth.
True diversification in a concentrated market
Diversification has always been a foundational principle of smart investing. You’ve likely heard the adage "don’t put all your eggs in one basket." Diversification is an investment technique that aims to increase returns and decrease overall risk by allocating across different investment types and industries.
Over the years, public markets have become more concentrated. In 1996, the number of U.S. publicly traded companies peaked at 8,134 before dropping to less than 4,300 in 2018. The decrease in publicly traded companies increases the challenge of achieving true diversification through traditional equity investing. Consider this: The top 10 companies in the S&P 500 now account for roughly one-third of the entire index. What’s more, most of these companies are in the tech sector.
Private equity, on the other hand, provides an opportunity to achieve deeper diversification. By investing in private markets, you can gain exposure to thousands of companies across a wide range of sectors and industries. Several of these sectors are underrepresented or entirely absent in public markets. For example, there are nearly 200,000 midsize companies in the United States, the vast majority of which are private. Midsize businesses account for one-third of private sector output and are predominantly private and not accessible through public markets. Investments into these companies can be accessed only through PE.
By including private equity in your portfolio, you gain access to different industries, market segments and business models that aren’t as susceptible to the concentration risks seen in market-weighted public indexes today, such as the S&P 500. Private equity investment is a way to broaden your exposure beyond the mega-cap, tech-heavy giants and reach into the broader economic landscape.
Alignment of interests for long-term success
One of the most beneficial aspects of private equity is the alignment of interests between investors and the management teams of private companies. Liquidity, a readily tradeable market and accessible information are strong benefits for publicly traded companies.
However, in public markets, companies are often pressured to prioritize short-term earnings to satisfy shareholders and analysts. This pressure can lead to decisions that undermine long-term growth.
In contrast, private equity is not under the same rigor. Often, private equity aligns management goals with long-term performance metrics. Compensation packages in PE-backed companies are often tied to the successful growth and operational efficiency of the business over a period of five to seven years and are typically aligned with a successful exit.
Private equity’s structure encourages strategic thinking and operational stability that benefits both the companies and the investors. Compared to public companies, board members of private companies typically have a significant investment in the company, prioritize previous experience and meet more frequently and often prioritize long-term value over short-term accounting profits.
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Proven superior performance
How did your investment perform? What was the rate of return? Did it make money? Investment performance is an investor’s scorecard. Past performance is no indication of future performance. However, when evaluating investment options, historical performance is an important aspect of decision making.
Ares Wealth Management Solutions, a leading global alternative investment manager, conducted research on the performance of private equity compared to public markets over the past three decades. Overall, the research illustrates private equity’s long track record of delivering superior, more durable returns compared to public markets.
For instance, their report highlighted how if you had invested $100,000 in private equity (buyout market, the largest and most mature private equity market) in 1992, today you’d be looking at an approximate value of $6 million 30 years later. This is significantly superior to the approximate $1.1 million value that the same $100,000 would have generated in public markets (represented by the MSCI World Index). This kind of outperformance should not be overlooked.
In addition to superior performance, private equity has also proven to provide better downside protection, thus less pronounced declines during market downturns and faster recoveries afterward, according to the Ares Wealth Management Solutions research. During the 2008 global financial crisis, for example, private equity experienced smaller declines and quicker recoveries compared to the broader public markets. The same downside protection and quicker recovery was also evident during the COVID-19 pandemic.
Know the risks
Private equity does come with risks; reduced liquidity and the need for a longer time horizon are certainly important factors in determining whether private equity is an appropriate investment. Investments are not listed on any securities exchange and may not be readily liquidated.
An additional risk that can adversely affect the performance of private companies is their reporting requirements. Private companies are generally not subject to SEC reporting requirements, are not required to maintain accounting records in accordance with generally accepted accounting principles and are not required to maintain effective internal controls over financial reporting. Due to the lack of reporting requirements, there is the risk that investors may invest based on incomplete or inaccurate information.
A powerful tool
Due to the ever-changing economic landscape, private equity’s potential benefits in terms of diversification, alignment of investor interests and historically superior performance make it an investment category worth considering. Private equity can give you opportunities that you would otherwise not have access to through public markets — potentially helping you find the right balance between risk and reward.
