Heeding the Unicorn’s Call: How to Invest in Private Companies as Public Stocks Shrink

How Does the Average Investor Invest in Private Equity?

Historically, private market investments have typically outperformed investments in public stocks.

In addition, while private equity has grown from a $30 billion asset class in 1995 to more than $4 trillion today, the number of publicly held companies has dropped nearly 50% since 1996, according to a recent McKinsey review of private markets.

Because of the cost, regulatory compliance and time commitment required to go public, most growing companies are remaining private longer than they previously might have. As a result, the U.S. now has about 150 unicorns, which are private companies valued at $1 billion or more.

Unfortunately for the average investor, historically only institutional investors and the very wealthy have been able to invest in private markets. Many private equity funds, for example, require investors to invest a minimum of $1 million or more.

However, that’s been changing. Today, virtually any investor has an opportunity to invest in private companies, although there still aren’t as many options for the average investor as there are for wealthy investors. The problem is that the average investor may not know how to invest in private companies and what options they have to enter the private market.

Prime Movers in Private Equity

Institutional and accredited investors have been the prime movers in the private equity world. Accredited investors must have a net worth of at least $1 million, not including the value of their primary residence, or have an income of at least $200,000 each year for the last two years (or $300,000, if married). Looking to avoid the relatively low returns from conventional stocks, bonds or money market accounts, these investors have increasingly turned to private equity, venture capital or hedge funds.

Two motivating factors for investors in private equity that stand out the most: return potential and diversification. According to Cambridge Associates, private equity investors globally have averaged nearly 13.6% in annual returns over the last 20 years. Venture capitalists that provided seed funding to start-up companies have done even better, realizing nearly 30% annually over the same time period.

Fortunately, many baby boomers with lengthy tenures and substantial deferred-compensation have reached the accreditation threshold.

Private Equity for the Rest of Us: How to Invest in Private Companies

But what about average investors (especially those nearing retirement) who need access to the diversification benefits and return potential that private markets offer? What types of private equity investments are available for them? Will smaller, retirement-minded investors be able to invest in private equity assets on a tax-advantaged basis?

Fortunately, private equity and start-up investments are no longer exclusive to the top 1% of the wealthy. While it may be beneficial to be wealthy for some investment opportunities, there are many opportunities that are more affordable. Innovations in fintech and healthcare are likely to keep the private equity momentum going.

Below are a few examples of how to invest in private companies if you are a non-accredited investor.

Business Development Companies (BDC)

BDCs have gained a lot of attention recently due to their high yield potential relative to more traditional, fixed-income investments. Investing in or lending to small- to mid-sized companies, BDCs provide managerial expertise to a firm in exchange for future profit potential.

The tax structure of BDCs resembles real estate investment trusts (REITs), in that they are required to pay out 90% of earnings as shareholder dividends. However, investors should proceed with caution and consider the potential for higher risk in pursuit of higher yields.

Public Private Equity Firms

Another popular investment class focuses on private equity firms that perform both buy-outs and venture capital activity themselves. These public private equity firms have historically given a boost to portfolios with somewhat less volatility than the public markets.

Equity Crowdfunding

Here, investors can invest in crowdfunding deals through websites that connect investors with specific companies. Equity crowdfunding is distinct from crowdfunding sites like Kickstarter, where entrepreneurs raise capital through the presale of their product, at a discount or through tiers of various perks and prizes to attract fans and potential customers. In contrast, equity crowdfunded companies sell securities in a variety of forms that includes equity in the company, debt, revenue share, convertible notes or other securities.

Equity crowdfunding is a small-scale version of private equity for non-accredited investors. Caveats include understanding that investing in these unlisted businesses is a high-risk versus high-reward proposition. Diversification and research are the keys to success here. Most start-ups fail, while others, like Google and Amazon, go on to succeed.

Private Markets Placement

When a company raises capital privately, rather than through a public equity offering, this is called a private placement. Although such investments are typically open to an unlimited number of accredited investors, the Securities & Exchange Commission’s Regulation D allows up to 35 non-accredited investors to participate in a private placement.

Investment Groups

In some cases, investors have pooled their resources to identify and invest in private equity deals. Members research investments and report back to these investment clubs, after which the group will vote on whether or not to invest.

Pension Plans

Defined-benefit pension plans have historically been significant investors in private equity, so if you have such a plan, you’re likely invested in private equity. Today’s 401(k) plans and other defined-contribution plans do not offer employees private equity options, but private equity firms have been advocating for regulatory changes to allow such investments.

Tips for Success When Investing in Private Companies

Alternative investments rooted in the private equity space can be complex. They can also come with higher management fees. Here are five tips for investors to maximize their chances for success:

1. Stay diversified. This is the key to ensuring that you don’t have too much single-name exposure to one asset. Portfolio diversification across sectors and business models is critical.
2. Understand fees. Fees from buy-out funds and private equity deals are often on the high side – approaching 2% annually on assets and 20% on profits. However, you choose to invest in private equity, make certain you understand the fee structure, as well as the potential risk.
3. Don’t invest too much. Limit your personal exposure to this asset class to only a small part of your overall portfolio – and stick to it. Amounts will vary according to financial circumstances and appetite for risk. Institutional investors, for example, typically allocate no more than 5% to 10% of their portfolio to venture capital.
4. Do your due diligence. Understand each selection’s business model. Consider speaking with company executives to understand their market. Ask questions like: “Do the owners work well together?” Also, choosing a business model or industry you know well can provide you with an inside advantage.
5. Vet the platform. Make sure that equity crowdfunding platforms have run successful campaigns. Determine if they provide any due diligence around the opportunities they present. Read through the terms and conditions very carefully.

Tax-Deferral Takeaway

Private equity has historically produced higher returns for investors than public markets. But that can also mean higher tax payments.

Investing in private equity opportunities through a self-directed IRA can be a powerful way to pursue return potential the tax-advantaged way.

Returns from a self-directed IRA investment may be tax-deferred or tax-free, depending upon the account type. Self-directed IRAs share the same tax advantages as a traditional or Roth IRA, but the Internal Revenue Service imposes certain restrictions on the management and use of these accounts.

When putting money into public equities, investors can sell their shares on the stock market if things go wrong. Private equity, by design, provides no such escape hatch. An investment in a start-up means investors get their money back only if the company goes public or is bought by someone else.

Similar to real estate, precious metals and other alternative investments, the administration and custody of private equity assets require a specialist who is familiar with the operational requirements of this emerging asset class.

It’s important that the average investors knows how to invest in private companies. Private equity can create a more diversified portfolio to help improve retirement outcomes when compared with a portfolio solely composed of equities and fixed income. And today more than ever, the average investor has access to the private market and its benefits.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: What is a “Private Fund?” and Due Diligence Before Investing.]

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