Private equity: It’s the high-stakes, high-reward game of Wall Street bigwigs and well-heeled investors, right?
Sort of. There’s big money to be made … but small investors have a growing number of ways to tap the space.
Private equity returns can be substantially higher than returns of traditional equity markets, especially when the economy is growing and small- to middle-market businesses are able to generate rapid growth in revenue and income. Over a 10- to 25-year horizon, private equity investments have been able to post better returns than the overall market and the major indices.
Private equity funds make money by investing in the debt or equity of various businesses. They get a return on investment by providing consulting services, as well as through management and financing fees to its portfolio companies, and capital gains when the investment is exited. Private equity funds can focus on an industry, a type of investment vehicle, investment criteria, geographical location or a myriad of other focuses in which management believes they can produce above-average returns.
Private equity investing has primarily been the playground of pension funds, university endowments, foundations, banks, insurance companies and high-net-worth individuals. The reason for the exclusivity is that the Security and Exchange Commission requires that investors in such funds be, at the minimum, accredited — which means an individual with income of $200,000 a year ($300,000 for a married couple) and reasonable expectation of making the same or more in the current year and a net worth of more than $1 million, excluding the value of his/her primary residence.
In addition, many private equity funds require investors to invest for, at a minimum, five years before seeing a return of their money which most investor are not able to do.
So, how can you and I join in this part of the investing world?
Private Equity for Mom and Pop
One of the easiest ways a small investor can get into the private equity game is to invest in the managers of the private equity funds. Recently many of them have become publicly traded such as Kohlberg Kravis Roberts & Co. L.P. (KKR), The Blackstone Group L.P. (BX) or The Carlyle Group LP (CG). Another indirect route is to invest in those same companies through an ETF like, PowerShares Global Listed Private Equity ETF (PSP) or publicly traded companies that Private Equity funds have taken public through ProShares Global Listed Private Equity (PEX).
A little too hands-off for you? Then you can dive into publicly traded private equity stocks, also called business development companies, or “BDCs.” BDCs are special investment vehicles that are registered with the SEC, are publicly traded, are required to maintain low leverage (total debt cannot exceed total equity), must be diversified (no investment can be more than 25% of total holdings) and must distribute up to 90% of their taxable earnings quarterly. They invest directly into middle market companies that Private Equity funds invest in as well.
The stricter requirements of a BDC produce stocks with nice dividends. Because of the dividend requirement, most of a BDC’s portfolio will be the debt of middle-market companies as opposed to equity, which also minimizes the possibility of huge returns that actual private equity funds are able to generate through pure equity investments. Still, BDCs are considerably less risky than pure PE funds.
In many respects, BDCs can be like going into a boxing ring with weak right hook. You can still do well — just don’t plan on knocking anyone out.
Invest in Private Companies Directly
BDCs still too far away from the action for you? You want direct investments in high-potential, untested private companies? Then consider investing in Special Purpose Acquisition Companies, or SPACs — also referred to as Blank Check Companies.
Just be careful — this type of investment has had a checkered regulatory past; thus, typically issuance ebbs and flows with the strength of the overall market and economy.
SPACs are essentially investing in reverse. A management team takes a company public and then looks for an acquisition to run. If it doesn’t find one that suits the team’s interest, then it returns the money. (Though this is a very unlikely outcome.)
With SPACs, a small investor can invest directly in a management team that targets certain types of companies and reap all the profits, or failures, of that investment directly. Some of the big asset managers have begun getting back into the SPAC game with Avenue Capital Group, known for its distressed private equity funds, and which recently launched a SPAC to find trouble companies in any industry and turn them around in two years.
Billionaire Wilbur Ross did the same thing and raised $435 million this year for his SPAC, WL Ross Holding Corp. (WLRH).
SPACs are not always easy to identify, as they are lumped in with all the other initial public offerings in the market. Especially with 2014 turning out to be a hotbed of new IPOs, identifying them is not always easy.
You also can shun the public markets and invest in startups yourself by taking a tour of your local business incubator. If you see a new technology or prospective business that interests you, talk to the CEO and see if you can strike a deal.
Young companies are always looking for cash.
But Wait! There’s More!
Small investors also can work with Registered Investment Advisors (RIA) to gain access to private equity “funds of funds,” which are funds that invest in private equity or hedge funds directly. The buy-in for these types of investments are typically smaller and can range from $100,000 up. Be careful, though: Fees are typically high because you’re layering the fees of the fund you’re investing in on top of the fees of all the funds held by your fund. Fun, right?
Private equity managers also are looking to woo small investors as money from pension funds and other sources fade. Carlyle is looking for ways to target the investable assets of doctors, lawyers and others with large brokerage accounts by working on new vehicles that allow for the direct investment of hundreds of thousands of dollars as opposed to millions.
Entrepreneurs are looking for ways to bridge the small-investor-to-private-equity gap. iCapital Networks offers an online marketplace where high-net-worth individuals and their advisors can search through a database of more than 2,000 funds for free. The company only charges a fee of less than 1%, compared to other intermediaries who charge up to 3% of the up-front investment and 50 to 150 bps per year thereafter.
All Investing is About Risk and Reward
Regardless of the investment vehicle you choose, the farther you go down the rabbit hole for higher potential rewards, the more work you will need to do, both to find and profit from private equity investments.
Also, don’t think that everyone who invests in private equity makes a windfall. Many don’t. Remember what happened to Chrysler? Chrysler was bought by Cerberus Capital Management in 2007 and ended up in a government takeover and a forced bankruptcy. Although the automaker was able to recover, it left a black eye and rivers of red ink for its former private equity owners.
Lesson learned: The potential for great returns typically is accompanied by great risk.
As of this writing, Kenneth Fick did not hold a position in any of the aforementioned securities. Write him at kfick@piercethefog.com or follow him on his blog at www.piercethefog.com.
