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High-net-worth investors have adopted the strategy of allocating a portion of their equity positions to alternative asset classes, including private equity investments. Private equity firms fund established companies or startups that have significant growth potential. They also try to turn companies around or improve their profits by changing the management team or streamlining business operations.
Private equity investing offers high returns that are not easily achieved through more conventional investment options. However, private equity carries a different degree of risk compared to other asset classes due to the nature of its underlying investments.
Key Takeaways
- Private equity funding supports investment in established companies or startups that have significant growth potential.
- Private equity investing often has high investment minimums, which can magnify gains but also magnify losses.
- The investment timeline for private equity investments is several years, leading to significant liquidity risk.
- Investors also face market risk, since many of the companies invested in are unproven, which can lead to losses if they fail to live up to the hype.
Understanding Private Equity Risk
Private equity firms pool investor money with other sources of borrowed financing to acquire equity ownership positions in companies with high growth potential. The investors are typically wealthy individuals and institutional investors, which are companies that invest money on behalf of their clients. Institutional investors can include pensions, mutual funds, and insurance companies.
Fast Fact
To invest in private equity as an individual, you need to be an accredited investor, which requires meeting criteria including a net worth of over $1 million, excluding your primary residence, and annual income of at least $200,000 ($300,000 with your spouse).
Private equity firms attempt to improve profitability at the companies they invest in by replacing the management team and board of directors. The firms also engage in cost-cutting, adding products and services, as well as selling part of the companies in a spinoff to raise funds. The goal is to increase the return on investment for the private equity investors involved.
Private equity firms are involved in several industries, including:
- Technology, such as telecommunications, software, and hardware
- Health care, including drug companies
- Biotechnology, which utilizes living organisms to help produce health-related products, biofuels, and food production.
Although this may seem like a smart investment strategy, there are a number of different risks associated with investing in small growth businesses, especially those that are still in their startup phases.
Investment Minimum
Private equity investing has a high barrier to entry, meaning it requires an enormous amount of capital for a minimum investment, which can be as much as $25 million. There are some private equity firms that cater to a lower threshold with investment minimums of $250,000, but they are still higher than most traditional investment minimums.
As a result of the large amounts committed, private equity investors stand to gain substantially on even a small percentage gain from their investment. However, investing can be a double-edged sword, meaning that those large sums of money can equally lead to significant losses from a negative return on investment.
Liquidity Risk
Liquidity risk is a concern for investors in private equity. Liquidity measures the ease with which investors can get in or out of investments. Earnings growth for small companies can take time, which is why private equity investors are expected to leave their funds with the private equity firm between four and seven years on average. Some investments require even longer holding periods before delivering any returns.
In other asset classes, such as stocks, mutual funds, or exchange-traded funds (ETFs), investors can sell an investment on the same day if needed. However, private equity investments do not offer that luxury.
Market Risk
Private equity investors also face greater market risk with their investments compared to traditional investments since there’s no guarantee that any of the small companies in which private equity firms invest will grow at all.
Fast Fact
About 1 in 5 startups fail in their first year, according to data from the U.S. Bureau of Labor Statistics—and some years are worse than others. Venture-backed startup failures increased 60% year-over-year in 2024.
An ineffective management team, a new product launch that fails, or a new, promising technology that becomes obsolete due to competitors can lead to significant losses for private equity investors.
Although other asset classes carry market risk, default risk is lower with more established companies. Also, private equity investments may involve the company using a significant amount of debt, which can be costly to service through interest payments over time.
How Do Private Equity Firms Manage Risk?
Private equity firms manage risk at all stages of the investment process, beginning with conducting due diligence before committing. On an ongoing basis, firms minimize risk by diversifying, hedging, using technology such as risk modeling tools, continuously monitoring investments, and actively managing liquidity.
What Is Private Equity?
Private equity involves investment in private companies in consideration of an ownership stake. Private equity funds generally buy established businesses, although they may sometimes invest in startups.
What Is ‘Carry’ in Private Equity?
Carried interest or “carry” is the share of profits due to a general partner of a private equity fund as their performance fee. Typically, carry is only paid if the fund meets a minimum rate of return (known as the hurdle rate).
The Bottom Line
Overall, the risk profile of private equity investment is higher than that of other asset classes, but the returns have the potential to be notably higher. For investors with the funds and the risk tolerance, private equity can be a lucrative investment for a portion of a portfolio.
