Are Private Investments Appropriate For You?
The capital markets have been the most accessible means of generating wealth for savers throughout the last 100-plus years. Traditional equity and bond markets have afforded anyone with the ability to set aside money for the intermediate- and/or long-term the opportunity to generate returns in excess of whatever has been readily available to them via traditional banking products (i.e. savings accounts and CDs). These markets have permitted individuals to accumulate the trillions of dollars that currently reside within 401(k)s and IRAs. But with equity markets near an all-time high and long-term interest rates still historically low (and for other reasons alluded to below), investors are clamoring for returns that might not realistically be available to them throughout the next 10 years by way of a well diversified equity and/or bond portfolio. For many investors, private investments are now an option and, in many cases, part of the solution.
Private investments have become increasingly popular amongst individual investors throughout the last 10 or 20 years. While institutional investors (i.e. pension funds and endowments) have been incorporating private investments into their allocations for decades, individuals have been developing an appetite for them more recently, and sponsors have in turn been making them more readily available. Real estate, private equity or debt, and venture capital are just a few of the areas in which individual investors can now invest, and hopefully benefit from the advantages associated with these opportunities.
As is the case with all investment opportunities, there are advantages and disadvantages associated with all prospective private investments. Outsized returns and diversification are probably the two most sought-after advantages while complexity and illiquidity are oftentimes the most concerning disadvantages.
We’ll begin with the disadvantages:
Complexity is difficult to define, but let’s consider the profiles below of two distinct investment opportunities:
• Option 1: the equity of a publicly-traded global consumer products company with annual revenues of $65 billion
• Option 2: the equity of a privately-held lightbulb manufacturer with annual revenues of $30 million
Perhaps this is overly simplistic, but most investors would agree an investment in Option 2 would entail more risk. A $65 billion footprint is massive while $30 million (in the grand scheme of things) is not. The privately-held manufacturer isn’t going to be subject to the same amount of regulatory oversight as the publicly-traded company (which could allow for fraud/mismanagement). Further, the manufacturer may very well have just one or two individuals who are responsible for most of the company’s biggest relationships, as well as its operations (what happens if one or both partners die or become disabled?). The business could also be heavily reliant upon just a few customers, which is inherently risky. Lastly, the legal structure of an investment in Option 2 could be complex, potentially necessitating professional legal advice.
Illiquidity is another risk that must be taken into consideration. Most private investments demand the forfeiture of an investor’s access to invested capital. Unlike capital markets investments, that can typically be turned into cash within just a few business days, private investments are generally “locked up” for a period of 3-5 years, if not longer. Because of this, investors in private investments should have other liquid assets available in the event an investment period ends up being longer than anticipated, or should the investment not pan out, as you can’t sell something while it’s “falling” if there’s no liquidity.
And now for the advantages:
Because of the aforementioned disadvantages, investors in private investments usually require a higher anticipated rate of return. The “liquidity premium” is the rate of return over and above otherwise readily available returns (via more liquid investments) required by investors. In many cases, the liquidity premium is particularly attractive, and compensatory for the amount of risk an investor is taking, which is why many investors are drawn to these opportunities.
Perhaps more importantly though, and why a lot of advisors are incorporating these opportunities into their clients’ portfolios, is the potential for private investments to provide for meaningful diversification. Some types of private investments have a tendency to “zig” while capital markets investments “zag.” Or at the very least, they’re able to “hold steady” while the equity and bond markets encounter volatility. With the proliferation of index funds, correlations have gone up considerably, whereby most equities behave similarly regardless of inherent value. This reality has made “avoiding” downturns increasingly difficult for equity investors, and private investments therefore more attractive. Is a hotel in Oxford, Ohio, or a Dayton-based, privately-owned healthcare firm really going to be impacted all that much by what’s at the root of a disappointing earnings announcement from a global technology company? Likely no, but if they’re publicly traded it probably doesn’t matter all that much because the baby’s likely to be thrown out with the bathwater.
Now with all this being said, private investments are definitely not for everyone. The aforementioned risks and illiquidity concerns alone should eliminate a lot of prospective investors. Requirements imposed by the SEC should eliminate even more. The accredited investor rule states an investor in private investments must have a net worth of at least $1 million (excluding a primary residence) or in excess of $200,000 of income ($300,000 for couples) throughout each of the last two years. Lastly, the complicated nature of many of these investments must also be taken into consideration. Many of these deals are particularly complex, and the terms of them might not be fully understood by the average investor. So most deals should be entertained by not only the prospective investor but his or her trusted advisor, who’s tasked with the due diligence that should be a part of vetting all investments.
We encourage you to have a conversation with a trusted advisor to determine whether or not private investments are appropriate for you.
Disclosure: All opinions and views mentioned in this report constitute our judgements as of the date of writing and are subject to change at any time. This material is not intended as, and should not be used, to provide investment advice and is not an offer to sell a security or a recommendation to buy a security. John D. Dovich & Associates, LLC is a Federally Registered Investment Adviser. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Information within this material is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Please remember that past performance may not be indicative of future results.
Chris Brennan, CFP®, with John D. Dovich & Associates, LLC, can be reached at 513.579.9400 or by email at firstname.lastname@example.org.
John D. Dovich & Associates, LLC is located at 625 Eden Park Drive, Suite 310, Cincinnati, OH 45202. For more information, call 513.579.9400 or visit www.jdovich.com. John D. Dovich & Associates is a Federally Registered Investment Adviser. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Information within this material is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.