Weighing Private Equity and Direct Investments

Investing in private companies may be appealing, but consider your options.

A man choosing which door to enter

Revised March 2017 — A 2014 survey suggests that an increasing number of high-net-worth investors are turning to direct investments in private companies for at least a portion of their overall portfolios.

According to Barron's, in the survey by McNally Capital of 100 ultra-wealthy families, 77 percent preferred direct investments in private companies as opposed to investing in private-equity funds. That number is up from 59 percent in McNally's 2010 survey. The families in the survey had a median net worth of $1 billion.* 

While this survey targeted an elite demographic, Adam Taback, Deputy Chief Investment Officer, Wells Fargo Private Bank, and Head of Global Alternative Investments for Wells Fargo Investment Institute, has seen more widespread evidence of this trend.

"Some investors may just be disenchanted with the private-equity marketplace and want a little bit more control of their investments," says Taback.

As Taback points out, "Today, we find that both institutions and high-net-worth investors seem to be turning to private capital (private equity and private debt) in a more significant way to access potential opportunities and illiquidity premium over what is a pretty 'frothy' equity environment. In fact, private capital is where our highest conviction outlook resides, and we believe offers the best return opportunity for investors in both debt and equity."

How private equity works
Private-equity funds invest in companies that are not publicly traded on a stock exchange through a mix of equity and debt securities. They are long-term investments that typically have long lock-up periods where investors are unable to withdraw their investment. 

Because of the illiquidity of these investments, as well as the risk associated with the types of companies in which they are invested — less transparency versus publicly traded companies, relatively young companies, or those in a turnaround situation — private-equity funds are only available to qualified purchasers within the meaning of the U.S. securities laws. A qualified purchaser is an individual with investments of at least $5 million or entities with investments of $25 million. There may also be other qualifications or requirements that apply. The reason for this high bar is that regulators believe that such investors are more sophisticated and better able to absorb any losses incurred from investments they designate as being more risky.

Private-equity funds, if held over a long period of time, have the potential to deliver good performance by tapping into high-growth companies and diversifying the potential risk of failure through investments in a number of companies. However, these types of funds do have a downside. They are complex, speculative investment vehicles that are not required to provide investors with periodic pricing or valuation and are not subject to the same regulatory requirements as other investment products. An investment in a private-equity fund involves the risks inherent in an investment in securities, as well as specific risks associated with limited liquidity, the use of leverage, and illiquid investments. Taback also noted the associated management and performance fees: private-equity managers typically charge between 1 to 2 percent of the investment, plus a 20 percent incentive fee if they meet certain growth targets.

Increasingly, however, there is a hybrid option that may appeal to the investor looking for private-equity opportunities without the fees attached.

"Private-equity funds in some cases are now offering investors the opportunity to put part of their investment into the private-equity fund, but also make a direct investment in the same firms in which the fund is investing," Taback says. In that case, investors can potentially earn higher returns on additional capital they invest directly. 

"It can be a pretty good way of investing in private equity if you want to maintain sufficient diversification while also gaining exposure to both private-equity funds and direct investment in specific companies," Taback says.

"Private investments may offer very compelling return streams that may supersede what you can get in the public markets." — Adam Taback, Deputy Chief Investment Officer, Wells Fargo Private Bank, and Head of Global Alternative Investments, Wells Fargo Investment Institute

How direct investments differ
Direct investments may give investors more hands-on control than a private-equity fund would, because the investor is picking a particular firm rather than a fund that is invested in multiple companies. According to Taback, however, there's a challenge to direct investments — managing the associated information flow and turnaround times can be difficult for some investors, who often need to make a decision about investing in a relatively short timeframe with limited information flow.

"Due to the hands-on nature of this approach, investing directly into larger private companies can be difficult for a high-net-worth individual to manage, given the response times required," Taback says.

In addition, direct investing in a privately held business usually doesn't have a specific exit timeline like private-equity funds do; however, because there isn't a public market for private company securities, getting capital back from a direct investment can be tougher and mean steep discounts. 

How timing plays a role in potential returns 
No matter which method of investing in private companies a qualified high-net-worth investor chooses, potential returns and timing are other important considerations in conjunction with diversification and risk exposure.

"Private investments may offer very compelling return streams that may supersede what you can get in the public markets," Taback says, adding that a stake in a company can allow investors to "unlock the value of that return through an active participation in that investment." 

Private-equity fund managers, for example, can help companies in their portfolios by providing them with capital to improve operations or make acquisitions to grow the business. That aid can lead to higher investment returns. However, such investments are riskier than investing in better-established companies or publicly traded companies with more robust balance sheets in the case of those that have been in business for quite some time and are now in a turnaround situation.

Whether it's through a private-equity firm or via direct investment, timing is critical in private investments, Taback says. 

"Private equities tend to be very 'vintage-year' focused," he says. "Vintage year is the year when the fund first began distributing investment capital. It's focused on the specific point of time that you're making the investment."

*Source: "Invest Like a Billionaire," Barrons.com, November 11, 2014

Mark Tosczak is an experienced business writer and marketing consultant based in North Carolina and a frequent contributor to Conversations.

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Global Alternative Investments is a division of Wells Fargo Investment Institute (the "Institute").  The Institute is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates.  

Alternative investments, such as private capital funds, are not suitable for all investors and are only open to "qualified" investors within the meaning of the U.S. securities laws. They are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund for which the fund does not represent a complete investment program. Private capital funds involve the risks inherent in an investment in securities, as well as specific risks associated with limited liquidity, the use of leverage and illiquid investments. These funds are not required to provide investors with periodic pricing or valuation and are not subject to the same regulatory requirements as mutual funds. Private capital investments often demand long holding periods to allow for a turnaround and exit strategy. A fund's offering documents should be carefully reviewed prior to investing.

The information and opinions in this publication were prepared by Wells Fargo Wealth Management. Information and opinions have been obtained or derived from sources we consider reliable, but we cannot guarantee their accuracy or completeness. Opinions represent Wealth Management's opinion as of the date of this publication and are for general information purposes only. Wells Fargo Wealth Management does not undertake to advise you of any change in its opinions or the information contained in this publication. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this publication.

This information is provided for educational and illustrative purposes only.

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