Private Equity: Potential Risks and Benefits

Private equity's popular reputation as the secretive preserve of the ultra-wealthy obscures the truth behind this asset class: It simply means investing in businesses and private assets outside of the public markets.

To be sure, investing in private equity can be complex and risky. But, as with any investment, understanding the innerworkings can help you account for those risks and potentially offer a different way to generate returns.

The private equity asset class consists of several strategies, but the most common is leveraged buyouts, or LBOs. In an LBO, a private equity fund generally makes a controlling investment—funded with combination of equity and debt—in a private company with the goal of making operational improvements to increase its value.

Other private equity strategies include venture capital, which invests in innovative startups; growth equity, which injects capital into established but growing companies; and distressed situations, which attempt to generate profits by turning around or restructuring struggling businesses.

Historically, private equity firms have pooled investor capital in what are known as closed-end funds. With this structure, a private equity firm aims to raise a set amount of capital that the fund manager—known as a general partner (GP)—invests as they identify acquisition targets. Typically, these funds use a drawdown approach, which means that the fund doesn't raise all the funds up front. Rather, the GP will issue calls for investor capital as needed to make investments.

Private equity drawdown funds typically have extremely high investment minimums, often $5 million or more. Access to these funds was frequently limited to large institutional investors that can afford to lock up their capital for a decade or more, which is the typical time commitment. As you can imagine, it takes time to identify acquisitions, make the necessary value-adding improvements, and then sell the assets to unlock any gains.

That said, this asset class is becoming more accessible thanks to the launch of evergreen private equity funds, which have minimum investments of as low as $25,000 and are intended to allow more frequent access to capital. Although far less liquid than publicly traded stocks or funds, evergreen funds' lower minimums and intention to provide periodic liquidity may give a wider pool of investors access to private equity investments.

The main argument for private equity is the potential for better returns than those available from publicly traded assets. Private equity funds delivered average annualized returns of 12.7% over the 25-year period through September 2024—nearly 5 percentage points better than the performance of global stocks during that period, according to an analysis by Cambridge Associates. 

To be clear, this comparison is based on the performance of traditional drawdown funds, not the newer evergreen structures. These two fund types differ in ways that are likely to affect performance. For example, a traditional drawdown private equity fund might hold only 10 to 15 positions, whereas evergreen funds tend to be much more diversified, holding hundreds, if not thousands, of positions.

Such concentration may be part of the appeal of traditional drawdown private equity funds. Funds that can successfully exploit market inefficiencies, pick better companies, or pursue better strategies for a business may be able to unlock bigger gains from a smaller number of select investments. This could create alpha, which refers to an investment's extra return relative to a benchmark, such as an index of publicly traded assets.

Evergreen funds, on the other hand, tend to offer a level of diversification that is closer to what you might find with benchmark index. As a result, such funds might offer returns that are closer to those benchmarks.

Regardless of the fund structure—drawdown or evergreen—private equity funds may still offer potential returns that surpass those available from public equities.

When considering private equity, it's important to weigh the risks related to both the fund's structure and the market's overall dynamics.

• Manager quality: The GP is arguably the most critical factor influencing a fund's success or failure. Their ability to identify, evaluate, acquire, improve, and sell a business for a profit directly determines the investors' returns—or losses. Finding GPs with solid track records and strong performance can be challenging due to a lack of transparent, standardized performance data, requiring investors to do their own due diligence into the GP's track record, investment process, financials, operations, personnel, and more.
• Fees and expenses: GPs generally charge two fees:
  • An annual management fee, often 2% of committed/invested assets, that's paid regardless of the fund's performance.
  • A performance fee (known as carried interest) due only if the fund's returns exceed a predefined threshold (the hurdle rate). Many funds use a hurdle rate of 8%; if they exceed it, the GP earns their performance fee, often 20% of profits.

Taken together, this "2-and-20" fee structure can substantially erode returns, requiring sizable outperformance relative to the public market to justify the cost.

• Financial exposure: Private equity firms may use relatively high levels of debt when buying companies. If a company in the fund's portfolio gets into financial difficulty, debtholders will generally be paid out first, leaving less in the fund for equity investors. Macroeconomic events, such as a recession, or operational missteps can also result in lower returns or even losses.
• Structural limitations: Investing in a private equity fund, even the more flexible evergreen funds, means committing to less liquidity and a longer investment time horizon than traditional investments. You may not be able to pull out your money if you need it, putting your financial situation at risk. There's also a significant reliance on the fund manager's skill; their ability to improve a company's financial results could have a significant impact on a fund's performance.

For those accustomed to the dynamics of public markets, investing in private equity requires a mindset shift. It can feel unnerving to have less access to your invested capital, but if you understand the mechanics and can tolerate the illiquidity, it could be a compelling option for generating excess returns compared to public markets and may help with long-term wealth creation.