Beyond the Buzz: Understanding Private Equity Investments

May 07, 2024

From time to time, we have clients that are interested in learning about private equity. Although these avenues don't align with our investment strategy (for reasons we'll discuss below), we acknowledge the curiosity and interest of clients and the attention it receives in the media.

Regardless of who you are, grasping the basics is crucial. I want to specifically discuss what private equity entails, set realistic expectations, and examine why it may not enhance your portfolio's value. 

What is Private Equity?

Private equity (PE) refers to ownership rights in companies whose shares are not listed on public exchanges (the stock market and public bond market). These investments provide capital to companies that cannot access capital through traditional public markets.

Investing in private equity provides exposure to a broad and unique set of businesses that are otherwise unavailable via the public markets. These investments typically offer a higher return potential along with lower correlations to public assets. However, that higher return potential comes with higher risk—the biggest risk being liquidity (your funds could be tied up for 5-10 years) and greater volatility in potential outcomes (promising upside with substantial downside risk).

Types of Private Equity Strategies

Private equity managers use various investment approaches in funds, each with distinct characteristics:

  • Venture Capital (VC)- Financing start-ups with high growth potential.
  • Leveraged Buyouts (LBO)- Investing in more mature businesses, often acquiring a controlling interest. LBO funds utilize significant leverage to amplify returns.
  • Private Credit (private bonds)- Raising capital from investors to provide loans rather than equity.
  • Private Real Estate- Managed funds investing in real estate, typically requiring a larger minimum investment and extended lock-up period.

In private equity funds, outcomes vary significantly compared to public markets, placing the responsibility on YOU to select the best-performing PE fund consistently. It's like trying to pick the winning stock within a specific sector instead of simply investing in the broader sector and benefiting from the overall stock appreciation of the rising winners.

The late Charlie Munger argued that the most sustainable path to wealth is not through extraordinary measures but consistently making intelligent decisions in your sphere of knowledge. He famously said at the 2007 Berkshire Hathaway Annual Meeting, "It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent."

Public markets provide that level of transparency, diversification, and a historic track record for achieving positive returns in the long run. This is an efficient and reliable way to achieve your future financial goals.

So, here is the framework we prefer to use at BCM when considering private equity with clients—evaluating the pros, cons, and trade-offs.

  • How much liquidity are you willing to sacrifice? How long can your funds remain inaccessible?
  • Does private equity truly diversify your portfolio? Public and private market correlations might surprise you.
  • What's the expected reward versus the opportunity cost of shifting allocation from traditional stock-bond portfolios to alternative assets?
  • Then comes the CRUCIAL QUESTION: what purpose does owning any percentage of private equity serve? Do you require that level of risk to achieve your goals?

We advocate for a long-term investment strategy aligned with the sustained growth of the U.S. economy through public financial markets. Employ diversification, low-cost funds, and broad market exposure to navigate toward your financial goals. Feel free to utilize us for your straw-man argument here. We are always open to engage in constructive discussions.