With The Return Of Stock Market Volatility, Should You Invest In Private Equity?

The stock market is surprisingly volatile right now. After a pleasant 2017 when stocks rose consistency throughout the year many expected 2018 to be pretty much the same, thanks to tax cuts, increased company profitability and a generally healthy economy.

But that’s not the way it turned out. Instead, we had a year of ups and downs, with stocks potentially rounding out the year lower than they were at the start.

Investors, however, need to ask themselves whether any of this is surprising. Let’s face it: stocks right now are expensive. Current P/E ratios are getting close to where they were in the run-up to the dot-com boom. And to be good value (for investors who follow Warren Buffett and Benjamin Graham), they need to be priced lower than the discounted present value of their future profit stream returned to shareholders after tax. Given current prices, buying shares in public companies means that you believe that profits will continue to soar in the future. The current prices seem to indicate that the market thinks that they will.

But there’s a problem: household income just isn’t rising at the rate that the economy needs to sustain those higher profits across the board. Salaries are going up much more slowly, if at all, meaning that the demand from the middle-class is unlikely to materialize in the way that stock prices seem to be suggesting.

It’s this concern about incomes (and possibly a trade war with China) that led to the volatility that investors created in the public markets in February and October this year. Investors worried that companies were too expensive, that they wouldn’t generate the promised profits in the future, and that they should seek returns in other areas. Many risk-averse investors also wanted to invest in assets with more favorable risk profiles for themselves and their clients: pensioners, for instance, do not want their assets fluctuating 40 percent in value from one year to the next.

Private equity offers an alternative strategy for investors. Rather than invest in the volatile public markets, private equity allows investors to escape many of the big swings that one sees in public markets and invest in long-haul projects designed to pay off in five, ten, fifteen years – and possibly longer.

Private equity is a different animal to buying stocks and shares in publicly traded companies. For starters, it’s not something that many investors ever do: it’s just not as easy as buying a stock or a share (for which there are dozens of brokers and apps). Instead, an investor has to go and visit the company, see whether it offers the potential for return, and then become an owner by buying private shares.

The upside, however, is that there tend to be more extreme opportunities to make money in private equity. Relatively few investors (at least compared to the public markets) are seeking profits in the sector, meaning that there’s a higher likelihood of finding a hidden gem: a company that could generate ten times the initial investment in a short space of time. Companies do exist on the public exchanges which offer ten times return in a single year, but they are fabulously rare, and their gains tend to peter out relatively quickly. Private firms tend to be under less scrutiny by analysts than those on the public exchanges, and so profitable opportunities are not competed away as much.

Lack Of Information

One of the reasons many retail investors shy away from investing in private equities is the lack of information available on privately trading companies. Reporting requirements for these companies are minimal, and so it can be hard to find out much about them to decide to invest.

Although it may sound counterintuitive, this is a boon for investors. As discussed, fewer analysts have their eyes on privately traded companies and, therefore, there are more opportunities for savvy investors to make incredible returns.

Take the example of Peter Thiel, for instance. Back in 2004, Thiel invested $500,000 in the then private, Facebook in return for 10 percent of the company. Thiel invested some of his money from the sale of Paypal in the firm, believing that eventually, Facebook would hold an IPO. Thiel then sold 16 million of his shares at the Facebook IPO in 2012 which valued the company at more than $100 billion, generating $638 million.

But Thiel had connections and knew his way around the tech industry pretty well. What about the average retail investor without access to this kind of information?

It turns out that there are still options. Investors, for instance, can work with a private equity firm – an investment broker who deals specifically with the issue of private equity. These institutions open up a whole new world of possibilities to the average investor, without the need for them to go and do their own research into private companies (which often restrict access anyway).

High Initial Investments

Investing in a private company often comes with “high-minimums.” High minimums mean that you have to stump up a minimum amount of cash to even be allowed to invest in a firm. Firms do this because of the high transaction costs involved in transferring private equity, and because they want to make sure that the people investing in their firms have proven financial acumen.

Minimums can be extraordinarily high. Some companies demand minimums more than $10 million, well outside of the range of most small retail investors. However, high minimums don’t necessarily mean that it’s the end of the road. Again, retail investors can go to private equity firms, pool their money together, and have the private equity firm act on their behalf when investing in private companies. Then, when the time comes to sell, the private equity firm can take the money from the sale, and distribute the profits among those who initially invested.

In short, retail investors should consider the benefits of investing in private equity. It offers fabulous returns and shields portfolios from the vicissitudes of the public markets.

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