Investors looking toward retirement often explore alternative investment strategies in search of opportunities to diversify their holdings. Stocks, bonds, mutual funds, and even rental property may not be enough. One option that works for some investors, including those using a Self-Directed IRA (SDIRA), is “direct private equity.”
But what is direct private equity and what does it do? How is it structured or set up? Which strategies can investors use to invest in private equity to diversify their retirement portfolios? How is it different from the stock exchange?
What is Private Equity?
The term "private equity" (PE) usually refers to funds that are exclusively focused and used for investments in private companies that have not been listed on the stock market or public markets.
In other words, it’s a way to provide private financing for companies through private equity funds. Capital is raised to invest in companies so that they will ideally perform better resulting in a higher return on investment. These type of private market assets are usually classified as long-term investments.
How Does Private Equity Work?
Typically, capital is raised through a "fund" to invest in these private companies. This capital usually comes from institutional investors, such as pension funds, sovereign wealth funds, endowments, and insurance companies.
Many privately owned businesses, for different reasons, want to avoid a public stock offering and turn to investors via private equity offerings. Sometimes the business owner may be looking to exit from the business they started. Other times they may need investment funds for cash flow, or they hope to meet a business goal, like kicking off new a venture or opening new facilities.
In general, investors can participate in direct private equity investments in two ways:
- through a “pooled fund,” where many individuals buy into a fund that’s controlled by a third party—a PE fund
- by a direct private investment in a company with limited partners, or LLC
Each investment vehicle sets its own rules regarding which clients to accept. However, many require clients to be an “accredited investor” or “qualified purchaser,” which limits membership to high-income or high-net worth individuals.
Depending on how the fund is established, the number of “pooled” investors can be limited at 100, while other funds can accept up to 2,000, again, depending on how the fund was set up.
Different Types of Direct Private Equity Investments
Investing in private markets may take several forms, which can include:
Focusing on VCs means a private equity firm will invest in startups and other young companies the firm believes have a high potential for maximum returns.
Leveraged Buyout (LBO)
A common private equity approach, LBOs use debt financing from banks or high-yield bonds to fund most of the acquisition. Then, when ready, the private equity firm sells the business at a profit.
This could be either commercial real estate or residential projects. Profits come back to the fund when the property is rented or sold.
A private equity firm or fund may also be focused on specific areas of a company, not the entire enterprise. Only one business unit may need a major investment to improve the performance of the company overall.
How are Private Equity Investments Structured?
When analyzing a private equity investment opportunity, investors need to consider whether they are limited partners (LP) or general partners (GP). LPs are stakeholders with limited liability like an individual, company, or institution that will invest in the private equity firm. The GP solicits crowdfunding from LPs and is fully responsible for managing the private equity investments portfolio. They must come up with ideas to pinpoint strategic business investments.
Private equity firms normally follow a 2/20% fee structure. A 2% management fee is applied to the total assets under management (AUM) that is not dependent on the performance of the investments under the fund manager. On the other hand, a 20% performance fee is charged on the profits that the hedge fund generates, beyond a specified minimum threshold. This fee is only charged when the fund achieves a certain level of profit.
Private equity investments unfold in stages over an extended timeline and can be broken down into three periods:
- “Collection” is the period, perhaps from two months to two years, where the fund's management team gathers investment commitments from clients. Then, the fund is locked.
- The “Investment” period can last up to five years. The fund managers search for suitable companies matching the fund’s strategy, conduct research, meet with decision-makers in a target company, and ultimately decide whether to invest.
- “Divestiture” may last several years. Many factors affect a decision to exit an investment—anything from the general state of the economy to simply finding the right buyer. After divestiture, the fund is closed, and all proceeds are distributed to investors.
- As you move forward with research, make sure you’re fully aware of the fund’s fee schedule, so you know what the investment will cost on an annual basis. Only then can you fully evaluate the bottom-line performance of a PE opportunity to that of other potential investments.
How Private Equity Fits Into a Self-Directed IRA?
Most retirement plans offered at big banks only offer investments in public companies or public stock. In order to invest in direct private equity, you need a self-directed IRA. However, the same rules apply to all IRAs.
Using SDIRA money to invest in a company that you own is prohibited. This is called “self-dealing.” Also disallowed are any transactions between you and a “disqualified person,” which include certain family members or businesses you are personally involved in. Breaking any of these rules may cause you to lose the tax-advantaged status of your account.
Investor Due Diligence
The private equity industry began in the United States more than 50 years ago. It’s been growing ever since, despite a slowdown during the pandemic. Many investors have enjoyed outsized gains, with private equity portfolios performing better than the S&P 500 by 5.2%, through the 10-year period ending in 2015, according to US News & World Report. The returns on private equity investments are, in most cases, higher than in the public equity markets.
Even with a major downturn in markets overall during the first half of 2022, The Pitchbook Platform (pitchbook.com) reports that the value of private equity deals still totaled $529 billion.
There is always risk when venturing into any investment, so it’s best to have a complete understanding of what’s ahead of you. You will only have your own independent knowledge and research to evaluate opportunities and risks. Anyone considering private equity as a part of an SDIRA strategy will want to know the distribution time or holding periods, and factor that into their overall plan for funding their retirement.
Keep in mind that with a private equity investment, the money is likely to be locked up between 2-10 years, so as an investment, it’s highly illiquid.
How Can IRAR Help?
Overall, private equity investments have provided significant gains for many self-directed IRA investors. If this is an investment of interest, make sure you are working with a knowledgeable IRA custodian.
IRAR Trust has been helping investors at all levels make informed decisions to self-direct their retirement portfolio. Book a free consultation with one of our experts to help you on your path to financial freedom through self-directed IRAs.