In the 1970s, a Stanford professor led studies on delayed gratification. Preschoolers were each given a sweet treat—like a marshmallow—and a choice. They could enjoy it immediately, or they could resist the urge for 15 minutes and earn an extra one.* Now, let’s replace that marshmallow with money. Could you set aside a portion of your capital for 10 years in hopes of greater returns? If so, you might want to consider private equity (PE).
How does private equity investing work?
In this type of investment, a fund manager selects promising private businesses, then connects them with the pooled resources of private investors. The investors commit a set amount of money (ranging from hundreds of thousands to millions) for an extended period (usually 7 to 10 years, with provisions for extensions). Typically, the capital is “called” in increments (capital calls), until the commitment is met. Throughout the process, the fund manager often works closely with the business to strengthen its foundation and improve its functionality, making minor to sweeping changes, as needed.
While there is, of course, risk—as with any type of investment—PE offers the potential for greater long-term reward. According to McKinsey & Company, private equity has outperformed other asset classes since 2008 and shown less volatility, even in the current period of recovery.3 In fact, a report from Burgiss showed that the top quartile of PE fund investments in the United States had delivered a 28.3% internal rate of return (IRR) for the 10-year period ending on September 30, 2020.**
What makes PE unique?
There are several factors that make private equity investing attractive to some investors, explains Ravi Ugale, managing director of private equity and credit strategies for Truist Advisory Services.
First, PE diverges from the public markets in some key ways. For one, PE fund managers are not obligated to shareholders and quarterly reports, so they can focus on the long game, not daily market fluctuations. This may be one reason there is not a strong correlation between how the two asset classes behave.**
There is also the sheer size of this investible universe. “There are more than 110,000 private businesses in the U.S. of investable quality, which means they have at least $15 million in annual revenue,” says Ugale. “Whereas the number of public companies on U.S. stock exchanges has reduced considerably in the last 10 years.” Thus, PE offers opportunity for additional diversification across the portfolio.**
Second, PE is, by nature, a long-term investment. Historically, this has meant its returns have been taxed at the rate of long-term capital gains, which has been lower than that of short-term gains. Its duration also makes it a possible vehicle for the transfer of wealth. “Private equity is one way to put money into family limited partnerships,” says Elena Vasilescu, senior vice president and investment manager for Truist Advisory Services (TAS). “Because PE is a long-term investment and this is a long-term goal, it just makes sense.”
Finally, private equity investing offers a sense of giving back. “Private equity firms bring expertise and contacts to these companies to help them grow faster and improve cash flow,” says David Rakestraw, senior managing director and financial advisor for the Private Client Group of Truist Wealth. “You’re not just investing in a stock; you’re helping a business to grow. That’s in the best interest of all stakeholders, including the employees, the customers, and the community.”
Why isn’t private equity investing in every portfolio?
Most of the downsides of PE are linked to the size of investment coupled with its illiquidity. In short, they tie up a great deal of money for a lengthy period of time. While it is possible to divest oneself from PE assets, it’s not an easy exit, and it typically involves selling below fair market value. Getting in the door can also be problematic: Many fund managers won’t work with people they don’t know and trust. And due to the lack of a reliable “index” or even observable market prices, it can be difficult for investors to make an informed decision about individual options.
**Sources: 1. “Kids do better on the marshmallow test when they cooperate,” Greater Good Magazine, February 24, 2020.
2. “Cognitive and attentional mechanisms in delay of gratification,” APA PsycNet.
3. “A year of disruptions in the private markets: McKinsey’s Private Markets Annual Review 2021,” McKinsey & Company, April 2021.
4. “Approach to private equity Q2 2021,” Truist Advisory Services Inc.
“S&P 500 returns to halve in coming decade—Goldman Sachs,” S&P Global, July 15, 2020.
“The NBA’s private equity plan is in motion and it’s betting on the allure of sports ownership,” CNBC, January 25, 2021. “ Private equity’s favorite tax break may be in danger,” The New York Times, April 23, 2021.
“Private investing for private investors: Life can be better after 40 (%),” Cambridge Associates, February 2019. “2021 long-term asset class outlook and capital market assumptions,” Truist, November 2020.
Disclaimer: The risk profile of private equity investment is higher than that of other asset classes and is not suitable for all investors. There are inherent risks in investing in private equity companies, which encompass financial institutions or vehicles whose principal business is to invest in and lend capital to privately held companies. These risks include a long-term investment horizon, rigid liquidity restraints, and high bankruptcy rates among portfolio companies. Generally, little public information exists for private and thinly traded companies and there is a risk that investors may not be able to make a fully informed investment decision. Past performance does not guarantee future results.