As the SEC considers allowing the masses to invest in private-equity funds, here’s what to know
A bigger world of investing could soon open up for small investors.
The Securities and Exchange Commission is considering allowing the masses to invest in private-equity funds, which typically buy stakes in nonpublic companies. Currently, such investments are restricted mostly to institutions and well-heeled investors, or those with a net worth (excluding their primary residence) of $1 million or more, or annual income of at least $200,000 for the past two years.
Regulators historically have tried to keep the not-so-rich away from private-equity funds, not wanting to expose people with limited financial savvy and resources to investments and fees they might not understand or be able to handle.
But prompted in part by private equity’s outsize returns, along with changes in other financial-market regulations, the SEC this year asked for public comment on whether it should ease access to the funds. The comment period closed in September, and the agency is widely expected to ease the restrictions, though when and how remains to be seen.
“I am a sincere believer in private equity,” says Jack Ablin, a founding partner of Chicago-based wealth-management company Cresset Wealth Advisors LLC. “It is a pathway to returns and wealth.”
Still, just because the government says investors can do something doesn’t mean they should. There are certain risks associated with private-equity investing, and it isn’t the right choice for everyone.
Here are things to consider when it comes to investing in these funds:
1. Higher returns
Private-equity returns have far exceeded those recently obtained from investing in the public markets, and easing the rules around access would open up this potential to a much broader population.
How big is the difference in performance?
For the decade through 2018, private-equity funds posted an average annual return of 14.2% compared with 7.3% for the S&P 500 index, including dividends, according to figures from financial-data provider Preqin and Morningstar, respectively. There are similarly large disparities in returns over other periods.
Past returns, of course, aren’t indicative of future returns.
2. An eager industry
The fund industry seems eager to attract small investors to private equity, and it might be good for them if the SEC moves to ease its restrictions. Indeed, small investors represent a new pool of capital for these funds at a time when another source of money might be drying up.
Historically the private-equity industry got a chunk of its assets from traditional pension funds. But pension plans, which pay out a steady stream of monthly payments to retirees, are quickly being replaced by 401(k)s and individual retirement accounts managed by individuals.
“What the SEC is aiming to do is to solve a problem that was created when there was a shift away from defined-benefit pensions,” says Kimberly Flynn, managing director of alternative investments at fund company XA Investments. “That change shifted the burden of investing to the individual.”
And while pension plans can invest in private equity, most individuals can’t through a 401(k) or IRA.
“We believe that the expansion of investment opportunities to include exempt offerings is important for investors to achieve their saving goals,” wrote BlackRock Inc., the world’s largest fund company, in a letter to the SEC. In a similar memo to the SEC, the Investment Company Institute said: “We welcome the Commission taking steps towards providing Main Street investors with access to new investment opportunities.”
3. Wide range of returns
While the returns from private equity have surpassed those available through mutual funds and ETFs, on average, investing in the subsector comes with risks.
The difference in returns between the top-performing private-equity funds and the bottom can be huge, according to a recent report from consulting firm McKinsey & Co. The report noted that while some top private-equity funds achieved annualized five-year returns above 40% for the half-decade through 2018, the worst private-equity funds saw yearly losses approaching 30%. For U.S. equity mutual funds over the same period, the spread of average annual returns ranged from a 5% gain to an 11% gain.
That means the returns of a subpar private-equity fund are likely to be far worse than the returns of a subpar mutual fund.
Some don’t think small investors are prepared for that.
Only 40% of U.S. residents have enough savings to cover an emergency costing $1,000, according to a recent survey from the Bankrate website. What if such individuals saw a $2,500 private-equity investment wiped out?
“It isn’t just a bad day; it is destroying what they are trying to do, which is to create wealth,” says Lance Roberts, chief investment strategist at Houston wealth-management company RIA Advisors, who argues against allowing nonaccredited individuals to invest in private equity.
“They don’t understand the risks even when they say they do,” he says. “And they don’t have the ability to withstand the losses when they occur.”
4. Manager risks are high
That variance in returns gets to another important difference between private-equity funds and mutual funds/ETFs: Mutual-fund managers don’t have a hand in running the companies they invest in, while private-equity fund managers often do.
“Unlike regular equity funds, the private-equity management has real control of the company,” says Bob Stammers, director, investor engagement, at the CFA Institute, who once worked in the private-equity industry.
Private-equity companies often hold board seats on the companies in which they invest and sometimes appoint new executive leadership to those companies. That’s especially true in cases where a private-equity firm takes a company private to turn it around, a common phenomenon in the industry, according to Mr. Stammers. The problem, he says, is that not all private-equity managers are skilled at turnarounds, and investors need to have enough knowledge to be able to spot that.
“There is the risk of the actual management that is really high, so you have to have confidence in the people you are investing with,” says Mr. Stammers.
5. Long-term horizon
Investors in private-equity funds generally must commit their cash for an extended period. That means once they put money in, they can’t demand it all back instantly, though funds do allow withdrawals of small percentages of investments periodically.
Private-equity investments aren’t liquid in any sense of the word, and investors need to understand that before they get in, says Mr. Stammers.
That lack of liquidity is part of the reason that the returns are better in private equity than in other asset classes. Lower liquidity and longer-time-horizon investments generally do better than others, he explains.
For Treasury bills, the investment horizon is weeks, whereas with public stocks, it would be around five to seven years, according to Cresset Wealth. For private equity, it is typically a 10-year minimum horizon.
Source: The Wall Street Journal