What is an Accredited Investor?
In Canada (as defined in NI 45 106), an “accredited investor” is someone, either alone or with a spouse, who owns financial assets with a net value of over $1,000,000 or whose income exceeded $200,000 over the past two years (or $300,000, if combined with a spouse). These high-net-worth individuals have a special status under Canadian financial regulation laws to participate in complex and higher-risk investments like private-equity deals. They do this in good company. Many of the world’s most revered institutional investors, including university endowment funds like those of Yale and Harvard, and massive pensions like the Canada Pension Plan, have been increasing their investments in private equity (Cf., David Kaufman, Financial Post, October 2, 2015). What about you?
Here are some points for the retail investor to ponder when considering an investment in private equity:
What is Private Equity?
“Private equity” refers to an investment in a company that is not listed on the stock market. Because these equities are meant to stand outside the public markets, professional private-equity and venture-capital firms often negotiate special terms that are not available to common shareholders. For example, private-equity deals often give access to preferred stock with liquidation preferences. Upon a liquidation event, these investors are paid out before other investors. This helps to protect these investors from losing money by making sure that they get their initial investment before other investors.
Why Do People Invest in Private Equity?
One of the attractions of private equity for institutional investors is that its exclusivity allows them to negotiate “sweetheart deals” that are not available to other investors. In addition, private companies are often undervalued compared to their publicly traded counterparts. One of the reasons for this undervaluation is lack of liquidity. Unlike on the public markets, shares in a private company cannot be traded on a daily basis. Since it is more difficult to sell them, the value of shares in a private company typically sell for less.
Private equity has also outperformed common equity. With an average annual return of 11.8%, private equity is the highest-returning asset class over the past ten years (Cf., Cambridge Associates Report on PE/VC Benchmarks). Private equity also provides diversification for an investment portfolio by smoothing out unsystematic risk. Unsystematic risk is specific to a company, industry, market, or economy. Diversification lowers this unsystematic risk by exposing the portfolio to securities that respond in different ways to market events (Cf., www. investopedia.com). As another asset class, private equity serves to further differentiate the investments in a portfolio.
Who Invests in Private Equity?
For decades, private equity has been used by big institutional investors and the ultra‑wealthy to generate superior, market-beating returns. University endowment funds typically allocate about 20% to 40%, and high-net individuals allocate over 20% of their portfolios to private equity. For example, private equity is the most highly allocated asset class in the Stanford University endowment fund (26%) (Cf., Stanford Management Company 2015 report). The Canadian Pension Fund currently allocates approximately 12% of its portfolio to private equity (Cf., www.cppib.com).
Private equity is also a favorite asset class of high-net-worth and ultra-high-net-worth individuals. For example, TIGER 21, a peer-to-peer learning network for high-net-worth investors, reports that investment in private equity continues its upward trend in the portfolios of its members, increasing over the past decade from a low of 10% to a high of 23% in the first quarter of 2016, the highest rate ever recorded for the group (Cf., www.tiger21.com). According to that report, TIGER 21 peers are increasingly allocating their portfolios to private equity to offset suboptimal returns in the public markets.
While private equity can work to provide increased performance and diversification in an investment portfolio, it is a comparatively illiquid asset class with terms ranging from 3 to 7 years or more. This makes it a desirable asset class for investors who seek higher portfolio growth and have the wherewithal to invest their money for a longer term. Remember, however, that that the risks of investing in private equity include, but are not limited to, speculation, volatility, secondary market, foreign exchange, and others. Private-company offerings are considered to be highly speculative and, as such, are not suitable for every investor.
Graham Wealth Partners