Private capital can help improve risk-adjusted returns, but it’s important to understand the risks before investing.
Should you consider private capital investments? Understanding what they are and the risks involved can help you make informed decisions.
The term private capital covers several different investment types, including private equity and venture capital funds for their growth potential and private debt and private real estate for their growth and income potential.
Venture capital and private equity funds offer you the potential to invest in fast-growing or restructured private companies that have the potential for more rapid growth than many publicly traded companies. Private debt lets you invest in debt to finance private companies, and private real estate offers ownership of equity and debt interests in different types of real estate properties.
Why is a wider array of investment choices important?
Expanding your investments into private capital offers you more choices to help meet your investment goals. What’s more, you may find that start-ups or smaller companies provide you better portfolio growth opportunities.
Private capital may also offer a greater degree of portfolio diversification. Private capital investments may react differently than publicly traded companies under certain economic and market circumstances precisely because they are not traded and have a longer time horizon.
Take, for example, if you have an income need. Instead of relying on income streams from bond or certificate-of-deposit interest or stock dividends, you may consider income from debt securities or a share of rents from high-end buildings, such as a fully occupied residential property.
What are some drawbacks?
There are a couple of notable drawbacks to private capital you should consider before you discuss the opportunities with your advisor:
First, you must be prepared to tie up your capital over several years. If you need to keep your investments liquid for some specific purpose, then private capital may not be right for you. However, in exchange for this illiquidity, the hope is that you will experience an illiquidity premium — in other words, higher returns over the full life of the fund.
Second, you will want to fully discuss the risk associated with these types of investments with your advisor. The fund in which you’re invested may not deliver the higher returns you expect, and you may pay higher fees to be invested in the fund.
There is a good reason why most private capital funds require investors to have a qualified purchaser designation — meaning they must have $5 million or more in investable assets and be deemed by financial regulators to be able to take on more financial risk than less-wealthy investors. There are additional qualifications for companies, trusts, and investment managers.
Take, for example, a private equity fund that seeks to take companies private, restructure the businesses, and sell them at a profit. If economic conditions deteriorate and the economy enters a recession, the fund manager may struggle to take the companies public or sell them at the desired price.
Contact your financial advisor
Determining whether private capital might be appropriate for you requires a conversation with your financial advisor, who can help you with an in-depth evaluation of your financial situation, tolerance for risk, need to access your money, and the objectives you want to achieve. Your advisor will also have detailed knowledge of specific investment options and their potential risks and rewards.
If you are willing to take on the illiquidity and other risks associated with private capital and have the resources to make these investments worthwhile, you will join a growing number of your peers who have made these types of investments a part of their asset allocation.
Wells Fargo Investment Institute, Inc. is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.
Private capital funds. Private equity and private debt funds are not appropriate for all investors and are only open to “accredited” or “qualified” investors within the meaning of the U.S. securities laws. They are speculative, highly illiquid, and are designed for long-term investment and not as trading vehicles. There is no assurance that any investment strategy pursued by the fund will be successful or that the fund will achieve its intended objective. Investments in these funds entail significant risks, volatility, and capital loss, including the loss of the entire amount invested. The increased risk of investment loss is appropriate 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.
While investors may potentially benefit from the ability of alternative investments to potentially improve the risk-reward profiles of their portfolios, the investments themselves can carry significant risks. Private capital funds are subject to market, funding, liquidity, capital, and other material risks.
They use complex trading strategies, including hedging and leveraging through derivatives and short selling and other speculative investment practices. The performance and volatility of a private capital fund will be materially different from the performance of a traditional portfolio. There is often limited (or even nonexistent) liquidity and a lack of transparency regarding the underlying assets. They do not represent a complete investment program. Private capital investments often demand long holding periods to allow for a turnaround and exit strategy. There is generally no secondary market for interests, and there typically are restrictions on transferring such interests. Private capital funds involve other material risks, including capital loss and the loss of the entire amount invested. A fund’s offering documents should be carefully reviewed prior to investing.
Private real estate funds. Core investments in real estate are considered less risky and are characterized as having lower risk and lower return potential. There is no guarantee any investment strategy will be successful under all market conditions. The value of any property may decline as a result of a downturn in the property market and economic and market conditions. The value-added strategy seeks to add value by making enhancements to properties. These properties may have operational issues and usually require additional leverage to acquire. There is no guarantee value appreciation will be achieved, and the operating company may be forced to sell properties at a lower price than anticipated. An opportunistic investment style bears the highest level of risk among real estate strategies as it typically involves a significant amount of “value creation” through the development of underperforming properties in less-competitive markets or other properties with unsustainable capital structures. Although these investments have the potential to generate income, there is no guarantee they will do so over their investment time periods. In addition, private real estate is considered illiquid. There is generally no secondary market for interests, and there typically are restrictions on transferring such interests.
Since the opportunistic properties have little to no cash flows at time of acquisition, higher leverage is often employed and sponsors may be subject to less-favorable debt terms and higher interest rates than more stabilized properties. All investments may be negatively impacted by varied economic and market conditions, which may be unpredictable.