Your investment advisor is always talking about diversification in your portfolio, which, generally speaking, is the right thing to do. Most advisors, though, are very limited in their ability and often lack the incentive to offer you investments in what’s called private equity. But what is private equity and why do so many people talk about it?
Private equity investments are shares of companies that do not trade on public stock market exchanges, hence the word private, and are often managed by private equity firms. These investments are offered only to a select group of investors and often only through word of mouth. These firms also have high minimum levels of investment, typically over $100,000.
The fees associated with private equity are also very high, because companies that make up this space must be rigorously analyzed and sometimes even partly or fully controlled by the private equity firm making the investment. Hence, private equity firms charge a litany of fees, including performance fees that can sometimes take 20% of your gross investment return.
The promise of private equity, however, is that the investor can profit substantially, over a longer period of time, earning many multiples over their original investment amount. With such a reward, there are also significant risks – the number one risk being you could lose 100% of your investment. The other major downside is that private equity investments typically need time to work, several years in fact. Most investors these days trade stocks far more frequently and do not want to tie up their money that long. Investing in private equity takes considerable discipline and patience and is reserved for sophisticated and accredited investors.
Not surprisingly, most investment firms in Canada don’t like private equity unless certain conditions are met that reduce the potential for risk and often restrict their clients’ investments into larger companies within highly managed and regulated private equity funds. The added regulatory burden increases the cost structure and limits the size of the companies private equity funds can invest into - larger and more mature companies. This unfortunately reduces the potential for investment returns.
I bet you’re thinking, well, this doesn’t sound good at all. Why would anyone do this? Earlier, I mentioned that diversification is important and one of the great benefits of private equity is that private equity companies are set for early-stage and often massive growth. Great, small, private companies have created a new market, have a new product, or have a new and better way of doing something that will simply take market share away from legacy companies in their sector – this is one of the best features of private equity: innovation.
Also, because private equity is not trading on a stock exchange, its shares are not subject to the whims of a fickle market during an economic downturn. This means that your private equity investment’s value is potentially increasing and making you money instead of losing it like your “blue-chip” portfolio of publicly traded stocks during a market sell-off, like we have currently experienced.
The key is investing in the right company. Aside from what I’ve mentioned above, there are many other factors that anyone considering an investment in a private company should spend time learning about. I am happy to offer advice to people in private equity investments and to discuss how to broach the subject with your investment advisor. It is important to work with your advisor to help you find suitable and direct investments in companies that exist within this space, so please feel free to reach out.
Romel Dhalla, President of Dhalla Advisory Corp., provides strategic corporate finance advice to companies and high net worth individuals and was a portfolio manager and investment advisor with two major Canadian banks for 17 years.