The road to wealth is paved with private investments (i.e., private equity) – investments in non-publicly traded companies.
It’s been the secret of ultra-high-net-worth investors (UHNWIs) for decades and one that is now out in the open, with the SEC even getting involved in making private investments accessible to more qualified investors.
UHNWIs consistently allocate the highest percentage of their portfolios to private investments. See the latest Asset Allocation Report published by Tiger-21, a social investing network with a minimum of $50M in investable assets required for membership.
So why private investments?
Higher returns. Because of their non-public nature and long-standing rules about advertising and general solicitation, private investments were traditionally the playground of the wealthy and connected. However, because of recent changes by the SEC, including the loosening of the advertising and general solicitation rules in limited circumstances and the expansion of the definition of an Accredited Investor (a qualified investor meeting certain income, net worth, and sophistication requirements), private investments are more accessible to more investors than ever before. In other words, they are no longer exclusive to the wealthy and connected.
So, why the big push to make private investments more democratic?
The simple answer is that they offer potentially higher returns at lower risk. The SEC itself acknowledged this fact a few years ago.
In a speech at the PLI Investment Management Institute 2020 in the summer of 2020, Dalia Blass, the Division of Investment Management Director at the SEC, made a surprising suggestion: Main Street investors need more access to private markets.
According to Ms. Blass, this is why private investments are a big deal:
“Private investments have the potential to provide stronger returns and diversification for investors, but come with both performance and liquidity risks. Defined benefit plans utilize the potentially advantageous returns while seeking to manage those risks.”
Private market investments can earn significantly higher returns than public equities. The following chart reflects this assessment:
The main takeaway from the above chart is that private investments have the potential to reward investors with higher returns than their public counterparts. However, they also have the potential to generate more significant losses as well as private investments also come with higher risk.
But if private investments come with a higher risk, how can they generate higher risk-adjusted returns?
UHNWIs can answer this question as they have figured out a way to mitigate the risks associated with private investments without sacrificing returns.
How? Smart investors have learned to mitigate risk by teaming up with the right partners. Many UHNWIs who are heavily allocated to private investments were once business owners and know what it takes to run a business successfully.
This business know-how is key to evaluating potential investment partners who will be in the business of managing whatever asset it is they’re raising money for. But you don’t have to be a current or former business owner to know how to screen potential investment partners.
Mitigate management risks by asking the right questions. Investors who ask the right questions can weed out high-risk management and settle on management with the appropriate skill and knowledge to execute their investment objectives.
These are the FOUR most important questions you can ask management to mitigate your risks in private investments:
What are the management’s background, experience, and successful track record?
When exploring the possibility of partnering with promoters asking for your money, it’s not enough that they have this sterling background, a ton of experience, and a documented track record of success. All this background, experience, and track record must also apply to the investment or asset. I’ve seen superstar managers from one segment try their hands at a new segment only to crash and burn. That’s not to say they don’t stand a chance in the new segment. Just make sure they’ve done their homework and have a clear plan.
What is the company’s investment strategy, and what are the major risks?
Management should have a clear investment strategy and a detailed road map for executing that strategy. In addition, this strategy and timeline should align with your investment philosophy and objectives.
What is the exit strategy?
Managers with a clear investment strategy and business plan should also have a clear investment strategy. Be cautious of open-ended answers to this question, indicating a need for more planning and focus.
What are the financial terms of the investment?
Make sure management can back up their claims and projections with math and data. A five-year pro forma is a good sign of management that has a finger on the pulse of the financial terms of the opportunity.
The key is in the details. Make sure management can explain or justify every number that appears in the financials.
Not all private investments are created equal.
Some will lose your money faster than you can say speculation, but if you understand that the #1 key to mitigating the risks of private investments is screening the right investment partners, your road to wealth will be less bumpy.