Private equity, the category of capital investments made into private companies, is an increasingly popular alternative investment option for those looking to diversify their portfolios.
In the first five months of 2021 alone, private equity deal volume rose nearly 22 percent year over year, resulting in more than 2,300 deals.
With a history of consistently higher returns than the public market and a current upward trend, it’s no surprise many individual investors are eager to start investing in the private equity space.
Here’s a look at how private equity investments work and how to start investing in private equity as an individual investor.
Access your free e-book today.
DOWNLOAD NOW3 Key Parties in Private Equity Investment
Before beginning the investment process, it’s important to understand the three parties in any private equity investment and the roles they play:
- Individual investors
- Private equity firms
- Companies receiving the investment
Individual investors—also called retail investors—are people with capital to invest. These individuals provide money to private equity firms in hopes that they’ll see a return on their investment. Once a firm has invested their capital, these individuals can be referred to as limited partners. In addition to high-net-worth individuals, pension funds and institutional investors can act as limited partners. As a limited partner, you’re protected from the possibility of losing more money than your original investment.
Private equity firms—also called general partners—pool limited partners' money and make strategic decisions about how to invest it. There are three key types of private equity strategies:
- Venture capital, which is an investment in an early-stage startup
- Growth equity, which is an investment in a middle-stage company’s growth
- Buyouts, in which a mature company is purchased outright with the goal of internal improvement
Private equity firms can specialize in one of these strategies or invest across all three. Because the return on investment depends on a business’s performance, private equity investments have long time horizons, typically no less than 10 years. While this can be a downside for some—you can’t access returns until the exit event—long time horizons can provide peace of mind that comes with a passive investment: Your money is working for you behind the scenes.
Investors contribute capital; firms pool, allocate, and manage the capital; and companies use the capital to hopefully generate returns. After a specified amount of time, returns are paid out to the firm’s managers (typically 20 percent of the total return) and split among limited partners based on how much money they originally contributed.
Now that you have an understanding of the key parties involved in private equity and how they interact, here’s a look at what it takes to get started as an individual private equity investor.
How to Start Investing in Private Equity: 4 Steps
1. Learn the Language of Alternative Investments
Before diving into private equity investment, it’s important to understand the language and field of alternative investments. Alternative investments are any investment besides stocks, bonds, and cash. Private equity is one of the many strategies that make up the alternative investment asset class.
To gain foundational knowledge, explore some of Harvard Business School Online’s blog posts on alternatives:
- What Are Alternative Investments?
- 7 Types of Alternative Investments Everyone Should Know
- 3 Essential Skills for Success in the Alternative Investments Industry
- Understanding Time Horizons of Alternative Investments
- 3 Key Types of Private Equity Strategies
- How to Analyze Private Equity Performance
Also, consider taking the online course Alternative Investments for a comprehensive understanding of the field and how to analyze private equity, real estate, hedge funds, and debt investments.
2. Become an Accredited Investor
Once you have a foundational knowledge of the industry, the next step is to become an accredited investor. Many fields of investment require this accreditation, including private equity, hedge funds, and some types of real estate.
To be considered an accredited investor, according to the United States Securities and Exchange Commission (SEC), you must either:
- Earn an income of more than $200,000 (or $300,000 with a spouse) in each of the last two years with a reasonable expectation to earn the same for the current year
- Have a net worth over $1 million, either individually or together with a spouse (excluding the value of a primary residence)
If you don’t meet these accreditation requirements, there are other fields of investment that don’t require you to be accredited. These are typically traditional investments, like stocks, bonds, and publicly traded real estate.
Private equity’s accreditation requirement is due to the unregulated nature of alternative investments by the SEC. Because investments aren’t regulated, private equity firms need a way to be reasonably confident that individuals who invest will be financially stable should their investments fail.
Determine if you fall into this category; if so, be prepared to share financial statements with the firm you decide to invest with to verify your net worth or income.
3. Research and Select a Private Equity Firm
The next step in the investment process is to research and select a private equity firm. It’s crucial to select one you trust because the firm’s managers will allocate your investment capital and control investment decisions.
While many private equity firms spread investments across strategy and industry, they can also occupy niche intersections. Consider your preferences based on personal experience and industry trends. For instance, perhaps you’re a seasoned tech entrepreneur, so you decide to research venture capital firms that specialize in technology.
Do your due diligence when researching a firm’s previous investments and the returns it’s provided for limited partners in the past. Most firms provide information about companies in their portfolios and their general approach to investing. Read any resources a firm provides about its strategy, including corporate social responsibility reports, which can provide details about the companies it chooses to invest in and the impact they’ve had on the environment and community.
Another important factor to consider is a firm’s minimum investment requirement. Historically, the standard minimum investment amount for private equity has been $25 million. Recently, however, some firms have departed from this high threshold to garner a wider investment base. Every firm’s minimum requirement is different—some are as low as $25,000. Make this a key focus of your research to ensure your investment is a good fit for the firm you select.
Once you’ve selected a firm that fits your investment restrictions and interests, you need connections in the field to get started. Many high-net-worth individuals use family offices—privately held companies that handle investments for wealthy individuals—or financial advisors because of their wide network of contacts in the investment space.
4. Track Industry Progress
After you’ve selected a private equity firm, verified your accreditation, and made your investment, the control of the investment will be in the hands of the firm’s managers. Although you won’t see returns on your investment for years to come, you can monitor industry trends to stay abreast of how your investment could be performing. Track trends in the specific industries of the companies receiving your investment, the private equity space, and the alternative investments industry as a whole.
Why Invest in Private Equity?
Although private equity investments come with uncertainty and illiquidity, the payoff is often worth both the risk and the wait. The investment capital you provide could help spur exponential growth for the business or businesses that receive it—whether that’s an early-stage startup, a middle-stage company ready for its next step, or a mature company that needs restructuring for a fresh start. The growth these companies see as a result of your capital contribution could provide substantial returns on your investment in the long run.
If you aim to start investing in private equity or other alternatives, consider building the necessary foundational knowledge and skill set by taking an online course, such as Alternative Investments. It can teach you the ins and outs of each investment type, different investment strategies, how to analyze investments, and how to build a strong, diverse portfolio.
Are you interested in expanding your knowledge of private equity and other alternative investments? Explore our five-week online course Alternative Investments and other finance and accounting courses.
