Today just about anyone can help fund world-changing startups thanks to the proliferation of crowdfunding platforms like StartEngine, Yieldstreet, and Republic. These are just a few examples of private equity investing, the secret weapon used by wealthy individual investors and institutional investors to achieve market-beating returns in a volatile economic climate.
Since the global financial crisis in 2008 private equity has become a hot topic amongst investors seeking differentiated sources of return and fatter profits. The McKinsey Global Private Markets Review 2020 shows their growth at 170% over the past decade versus 100% for public markets.
Looking to the future the private market looks set to dominate investment with Preqin forecasting that assets under management for private equity and venture capital would more than double from $4.41 tn at the end of 2020 to $9.11 tn in 2025.¹ Overall there’s no doubt that more and more companies are staying private and for longer; the number of listed companies in the US has almost halved between 1996 and 2018 according to the World Bank while aggregate market cap has continued to rise.
In this guide we’ll dive deep into private equity and explore the types of investment opportunities currently open to retail investors.
Private equity (PE) is any form of capital investment made in companies that are not publicly traded. It’s a broad term that can include venture capital, angel investors, and corporate takeovers by investment funds. Banks are often reluctant to lend to startups, making private equity a crucial source of funding for seed and early-stage companies.
A significant outlay of capital is typically required which is why the industry is dominated by institutional investors like pension funds, large private equity firms, and accredited investors who must meet high income or net worth criteria to qualify. Smaller investors are also able to invest in private equity through non-direct vehicles like stocks and ETFs or equity crowdfunding through platforms like StartEngine, Yieldstreet or Republic.
Within the private equity sector there are four key investment types that we’ll dig into in greater detail later in this guide:
Typically a minority investment in a high-growth company with minimal revenue which does not have access to debt markets to raise capital. Investments are usually made at an early stage in the company’s life cycle in return for equity stakes. These deals are usually characterised as high-risk, high-return due to the high failure rate of startups, but VC investors can see tenfold or even higher returns should the company prove successful.
Most VC firms won’t invest in companies that don’t have a solid track record, which is where angel investors come in. They’re typically wealthy investors who fill in the gap, providing funding for very early stage startups to facilitate their research and development and help develop a market-ready product. They either operate independently or band together in syndicates or clubs. Since this is a high risk investment strategy, most angel investors spread their risk by buying into multiple companies.
Whereas VC firms take a minority stake, with a buyout an investment firm or consortium purchases an underperforming or undervalued company that can be “flipped” for a profit. This is the core strategy for most private equity firms. Leveraged Buyouts occur when the target company’s assets are used to secure the loan to purchase it, with the debt usually representing 60-70% of the purchase price. As the company’s value increases and the debt balance reduces, the equity can grow very quickly and generate substantial returns.
PE firms also buy distressed companies which can be rescued and resold for a profit. The advantage here is that these failing firms can be picked up for a heavily discounted price, which can result in exceptional returns if the company can be restored to financial health. Be aware that these can be very risky investments! Most PE firms will spread their risk and take small positions to limit their exposure.
Most of these investment types are restricted to institutional investors and accredited investors who meet certain income or net worth criteria. Smaller retail investors are able to gain exposure to private equity through indirect investments such as buying stock in PE firms, ETFs, funds of funds, and crowdfunding platforms like WeFunder or StartEngine. We’ll talk more about how retail investors can get involved in private equity as we go through each type of investment in this guide.
The main attraction for retail investors is that private equity typically provides higher returns than other private market strategies. According to Pitchbook, growth equity funds have provided a 13.3% 15-year IRR (Internal Rate of Return)², beating private debt, funds of funds, infrastructure, and real estate. Buyout funds came in close second, with 12.5% 15-year IRR. The S&P 500, in contrast, lags further behind at around 9.7% annually³.
If you invest in a PE fund, you become a limited partner. This means you will receive a return on your investment when the PE fund eventually sells the company you’ve helped purchase. Should things go wrong, limited partners have limited liability so the maximum amount you can lose is your total investment in the fund.
Private equity provides access to investments and market segments that are impossible to reach through public markets. It can be a useful way for investors to diversify their portfolio and improve their risk/yield profile.
PE firms often have an investment horizon of 5-7 years. This lengthy time frame can be problematic for retirees who need to withdraw from their 401(k) or IRA.
The high net worth income requirements to become an accredited investor excludes many retail investors. Traditional private equity funds usually also have hefty minimum investment thresholds. Smaller investors can access this industry through indirect investment vehicles like stocks and ETFs as well as private equity crowdfunding platforms.
PE funds are not subject to the same regulations as publicly-traded mutual funds and have no standard disclosure or performance reports.
Venture capital firms or funds identify early-stage startups with high growth potential that are looking to raise funding in return for equity. These companies will then either be taken public with an IPO (Initial Public Offering) or sold privately to the highest bidder. Unlike private equity firms, VC firms typically take a minority stake when investing in companies.
The first round of funding most startups go through is known as seed-stage financing. At this point the company may not even have a product or service ready to go to market, so early investors take on greater risk. Additionally, investors may have to wait a long time to see any return, given that the median age of a startup at its IPO for 2001–2019 was 10 years old⁴. Initial seed investments usually range between $250,000 to $1 million.
This stage is followed by the startup and early stages as the company moves closer to commercial viability and ultimately profitability. According to Pitchbook, the median age of companies receiving seed funding was 2.9 years versus 3.5 years for early-stage funding in 2019.⁵
Late-stage venture capital targets companies who usually have a well-established market presence and are either profitable or approaching profitability. Companies at this stage may be raising funds to position for an acquisition or IPO. In this scenario investors are often seeking liquidity and may have less appetite for risk compared with early or seed stage investors. These investments usually have less upside potential, typically returning at least a 3x multiple on the invested capital.
Between the start of 2021 and mid-June a record $17 billion was invested in cryptocurrency.⁶ Interest in the sector, especially in decentralised finance (DeFi) and NFTs, is at an all-time high amongst venture capital firms.⁷
In the DeFi space so-called “VC Coins” look similar to a VC-funded startup with funding rounds. Examples of crypto projects that have raised funds from private investors include Hedra Hashgraph and Orchid. Going down the VC route has advantages over Initial Coin Offerings (ICO) for founders, giving them access to business consulting and professional networks to help them grow and scale.
Venture capital can be difficult for retail investors to access since funds are restricted to only having a limited number of investors. Proven VC firms will usually have a long list of previous investors who will get priority on new opportunities. Venture capital is normally the preserve of institutional investors like pension funds, university endowments, insurance companies and a small number of accredited investors.
As of Q3 2020 VC has outperformed all major asset classes over the past three years. According to Pitchbook, 2020 was also a record year for venture fundraising with almost $80 billion in fresh capital.
Early-stage startups often can’t provide much data on earnings and operations, meaning investors are reliant on PE firms to identify companies with solid potential. Risks are higher than investing in growth companies which already have established market share and revenue.
VC is regarded as a higher risk investment vehicle given that venture-backed startups have a 75% failure rate.⁸ Of these, 30-40% liquidate the assets so investors typically lose their entire investment.
VC firms tend to be unwilling to invest in companies that don’t have a proven track record, so many entrepreneurs or very young firms meet this funding need by connecting with angel investors. They are wealthy individuals who come in at a very early-stage to provide funding, and often also business advice, in return for equity.
Angel investors often invest in businesses that have only just developed a MVP (Minimal Viable Product) and need funding to continue their research and development and bring their product or service to market.
Angel investors operate independently, identifying new opportunities and investing their own wealth in exchange for a minority stake. Individuals also join together to form angel investor clubs or syndicates like Angellist which have the advantage of sharing the legal and administrative costs of conducting a funding round.
This strategy is regarded as higher-risk than other types of investments since 9/10 new businesses fail. There is the risk you could lose your entire investment. This is why most angel investors invest in multiple companies to spread risk and increase their chances of picking a winner. Losses are to be expected and offset against the return from any successful startups.
Angel investors are normally accredited investors due to the risks involved in this type of investment. You must have a net worth of over $1 million or an annual income of at least $200,000 to qualify.
For a young startup to grow to the point at which angel investors can make a healthy profit, you’ll typically need to wait 7-10 years.
Since they are investing at a very early stage, angel investors can often buy in at low valuations. If the business does become highly successful, this can lock in considerable upside on their initial investment.
Angel investors may invest as little as $5,000 or as much as $1 million.
Another attractive feature of angel investing is the opportunity to support promising entrepreneurs and help to realize exciting ideas.
Buyouts occur when a private equity fund or firm purchases a mature company intending to sell it later for a profit. Public companies can also be subject to buyouts, becoming private through the purchase. Leveraged buyouts (LBOs) involve company assets being used to secure a loan to buy the firm. It’s a strategy that’s similar to house flipping; private equity firms come in and make improvements to the management or operations of a struggling company in order to sell it on at a profit.
Buyout funds are usually a type of private equity fund, which means they are only open to institutional investors and accredited investors. Limiting access to these categories reduces their regulatory burden compared with more public investment vehicles like mutual funds.
One example is the LBO of Hilton Hotels by Blackstone Group for $26 billion in 2007. The deal was financed by $5.5 billion in cash and $20.5 billion in debt. After improving operations and refinancing at lower interest rates, Blackstone sold its last shares in Hilton in 2018.⁹ Blackstone realised a total profit of $14 billion, almost triple their initial cash investment.
LBOs are regarded as riskier as the debt places an additional financial burden on the company. In the event of an economic downturn or sudden increase in costs, the company could struggle to meet all of its financial obligations.
Also known as “vulture financing”, distressed private equity focuses on failing companies which can be turned around and sold for a profit.
This strategy focuses on the financial obligations of companies that are heading for or have already filed for bankruptcy. These bonds are purchased at a heavy discount of their face value with the potential for substantial
profits if the company can recover viability. This tends to be a high risk investment, so investors often take small positions in distressed companies to limit their exposure.
“Loan to own” or debt control involves the purchase of distressed company debt with the view to convert it into a controlling stake once the business is restructured. On the other hand, distressed debt non-control investors are not actively involved in restructuring, making it easier for them to adjust their positioning as prices appreciate.
Retail investors have limited access to distressed private equity, although they are able to invest in public debt issued by public companies. Large brokerage firms like Citi and JP Morgan connect institutional investors with distressed securities.
Distressed companies usually trade at very low multiples, which can create potential for excellent future returns.
Prices often understate the true value of a company to be attractive to investors.
Debt tends to be less liquid than stocks. For improved liquidity investors can focus only on debt issued by larger companies.
As with other types of private equity investments, there will likely be less information available for distressed companies that do not issue SEC filings.
Distressed private equity can be highly volatile and there is a high risk of permanent capital loss.
For investors who don’t have the capital or income to qualify as accredited investors, there are still numerous opportunities to invest in private equity.
Many venture capital or private equity firms are publicly-listed companies. Well-known examples include KKR & Co. (KKR), Leucadia National Corp. (LUK) and Blackstone Group (BX).
Funds of Funds are quite simply funds that invest in other mutual funds (MFs) or exchange traded funds (ETFs). Some pool capital from many smaller investors who do not meet the criteria to be an accredited investor, giving these retail investors indirect exposure to private equity.
Smaller investors can purchase exchange-traded funds (ETFs) that hold shares of private equity firms. One example is ProShares Global Listed Private Equity ETF (PEX).
Another option is to look at special purpose acquisition companies or SPACs which are an alternative to a traditional IPO. These are “blank check” shell corporations that are designed to take companies public. SPACs go public as shell companies and then acquire target companies to take them public. Recently high-profile names like BuzzFeed and Taboola have opted to go public via a SPAC instead of an IPO. This mechanism can give greater stability and speed as well as offering the option of forming a strategic partnership with the SPAC shell corporation.
Retail investors are excluded from the upside available from a traditional IPO, but they can get involved in a SPAC after it has gone public and before it announces an acquisition or merger.
The global crowdfunding market was worth $12.27 billion in 2019 and is forecast to hit a staggering $25.8 billion by 2026¹⁰. It’s an increasingly popular option for very early stage companies that can’t access bank loans or don’t want to enlist an angel investor.
This type of investment is also a great way for smaller investors to get exposure to private equity. Platforms like Wefunder, AngelList, Republic, or StartEngine connect individual investors with businesses who are looking to raise funding in return for equity. The SEC typically sets limits on how much individuals can invest, capping it at 5% of your annual income for those earning $40,000 - $100,000 or 10% for those earning over $100,000.
It’s never been easier for retail investors to get involved in private equity thanks to pioneering crowdfunding platforms and the growing popularity of angel investing. And with private markets expected to dominate investment into the next decade, this might just be a golden opportunity for investors willing to swap higher risk for a chance at market-beating returns.