An Introduction to Private Markets
Retail investors often focus on more conventional asset classes like stocks, bonds, ETFs, and mutual funds, each of which is readily accessible to the public and considered highly liquid. However, the last few years have seen more investors venture off the beaten path and into the world of private markets—a world that was once reserved for institutional and accredited investors—in search of diversification, inflation protection, and most of all, a chance at earning outsized returns.
According to McKinsey’s 2022 Annual Review, private market fundraising has grown by nearly 20% since the start of the Covid-19 pandemic and 170% over the course of the last decade. Last year alone, $1.2 trillion was raised privately despite growth concerns coming out of the pandemic-imposed lockdowns. These figures underscore the growing allure of the private markets to investors.
Why can this be such an appealing method of investing? Let’s find out by discussing the potential benefits and risks of engaging in the private sector.
Investing in the private markets means investing in the debt or equity of companies that aren’t publicly traded, with private equity (PE) accounting for the majority of these investments. By funding private companies, investors hope to help them grow, thus increasing their market value until it’s ultimately time to turn a profit. Investors can profit in a number of ways, such as selling their stake to another investor, the company getting recapitalized or bought out, or by the company “going public” with an IPO.
Traditionally, access to these markets has been restricted to high-net-worth and institutional investors because of the steep cost, relatively long time horizon, and high level of risk associated with owning a stake in a company. However, the SEC’s Regulation A has opened the door to private markets to retail investors and now there are more ways than ever to get involved.
Potential Benefits of Investing in Private Equity
Private equity investors are generally enticed by the promise of excess returns and a lower correlation with the broader market. Among the benefits that private equity can afford its investors are:
- Access to modest market values for up-and-coming companies.
- Diversification within their investment portfolios.
- Exposure to companies throughout their lifecycles.
- The opportunity to provide strategic guidance to a company and steer its growth.
But the advantages of investing in private equity don’t stop there. As the previously-cited McKinsey report notes, private equity investments consistently outpaced most comparable measures of public market performance between 2000 and 2020. They also experienced less volatility over that same period.
In its 2020 Private Investment Benchmarks report, Cambridge Associates indicates that its private equity index produced an average annual return of 12.84% over the past quarter-century. Over the same 25-year period, the small-cap-focused Russel 2000 index returned 8.16% while the S&P 500 only delivered a 9.27% return. Needless to say, the tendency of private equity to outperform public equity can make it an attractive sector for investors to engage with.
Despite some of these alluring factors, investing in private equity entails risks that bear consideration.
Risks of Investing in Private Equity
As with any type of investment, there’s no surefire way to ensure the success of your private equity venture. In fact, the sector can be riskier than most. Private technology, bio, and pharmaceutical companies, for instance, have the potential to produce significant returns—but these are also some of the most volatile, high-risk industries for investors to navigate. For each company that succeeds in delivering excess value to its investors, there are more than a dozen that fail and leave their investors with headaches and sunk costs.
Because so many small companies fail before they even have the chance to reach profitability, it behooves investors to do their research on the businesses they want to support before committing their capital. Complicating this task is the fact that private
companies aren’t subject to the same reporting requirements as public ones. This can make digging into a business’ fundamentals to assess its viability more of a challenge, particularly for retail investors whose resources may be more limited than institutional ones.
In addition, private equity tends to lack the liquidity of traditional investments. Funding startups and other small companies can mean tying up your money for an extended period before you can reasonably access it. Depending on the stage of the business you choose to invest in, it can take years for these businesses to start producing returns, which can make it harder to sell your equity if you want to.
How to Start Investing in Private Markets
In the past, private equity involved purchasing a stake in a company directly, which required one to be well connected, or by way of a private equity fund. These funds typically require substantial investment minimums, ranging anywhere from hundreds of thousands to several million dollars. Due to this, plus the previously discussed risks, private markets have historically been exclusive to high-net-worth individuals and institutional investors—but that’s changing.
Regulation A by the SEC expands access to private equity and offers opportunities to investors of all kinds, not just accredited ones. If you’re curious about investing in private equity despite the risks that are inherent, here are three of the most popular and accessible ways to start investing today:
Special Purpose Acquisition Companies (SPACs): SPACs are a type of publicly-traded shell corporation that aims to identify undervalued private equity companies for the purpose of merging with or acquiring them. For this reason, they’re sometimes called “blank check companies” because they fulfill no operational function in and of themselves. Due to the nature of these investments, SPACs can deliver tremendous value to their investors but also entail a high level of risk.
Fund of Funds (FoF): A fund of funds is a type of pooled investment that can provide exposure to the private markets. Instead of holding traditional securities like stocks and bonds, FoFs invest in other funds, as the name suggests. These “multi-manager” funds often charge fees that should be considered as part of your assessment.
Exchange-Traded Funds (ETFs): An ETF is another kind of pooled investment vehicle. Similar to mutual funds, ETFs track and buy shares in publicly-traded companies. In this case, a private equity ETF invests in private equity firms that are adept at picking and raising capital for up-and-coming companies. Investing in an ETF that tracks these firms means you can share in their success without having to contend with a hefty up-front investment minimum.
The private markets can be difficult for individual investors to navigate, particularly for those without previous experience in the sector. To learn more about this opportunity, or to discuss your options, reach out to a financial professional today.
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