Private equity is an attractive investment option for high-net-worth individuals and institutional investors because of its potential for high returns. Private equity falls under the category of alternative asset classes.
Although its definition is muddled, private equity most commonly refers to a managed pool of raised or borrowed funds. These funds are explicitly used for obtaining an equity ownership position in smaller companies with growth potential. Private equity firms encourage investment from wealthy sources by boasting greater return on investment (ROI) than other alternative asset classes or more conventional investment options.
Key Takeaways
- Private equity produced average annual returns of 10.48% over the 20-year period ending on June 30, 2020.
- Between 2000 and 2020, private equity outperformed the Russell 2000, the S&P 500, and venture capital.
- When compared over other time frames, however, private equity returns can be less impressive.
- A high degree of risk tolerance and the ability to handle substantial illiquidity are necessary for success in private equity markets.
Historical Returns of Asset Classes
The U.S. Private Equity Index provided by Cambridge Associates shows that private equity produced average annual returns of 10.48% over the 20-year period ending on June 30, 2020. During that same time frame, the Russell 2000 Index, a performance tracking metric for small companies, averaged 6.69% per year, while the S&P 500 returned 5.91%.
It is clear that an investor taking a risk with private equity would have received a much higher return than those who chose the more conventional route of investing in an ETF that tracked a popular index. Furthermore, the Cambridge Associates U.S. Venture Capital Index averaged just 5.06% per year between 2000 and 2020.
When compared over other time frames, however, private equity returns can be less impressive. For example, venture capital was the top performer between 2010 and 2020, with an average annual return of 15.15%. Furthermore, the S&P 500 slightly edged out private equity, with performance of 13.99% per year compared to 13.77% for private equity in the 10 years ending on June 30, 2020. On the other hand, that was still better than the 10.50% average annual return of the Russell 2000 during that time.
Differences in Valuation of Public and Private Equity
While it is generally easy to determine the price and performance of publicly-traded companies and funds, private equity and venture capital present additional issues. For public companies, one can simply observe market prices and measure the changes in prices to obtain historical returns.
There are a variety of methods for valuing private companies. One approach is comparable company analysis, but that only works if there are public companies similar to the private company in question. It is also possible to calculate the book value of private companies if their balance sheets are available.
The best estimates of private company valuations are usually made by private equity firms. Firstly, they need accurate estimates in order to know how much to pay when they invest in private companies. After buying in, private equity firms will also need a steady stream of reliable data, such as balance sheets, for decision-making and providing information to their investors.
The major issue with using valuation metrics, such as book value, for comparing private equity returns with public equity is that they behave quite differently than market prices. For example, book value is much less subject to short-term swings in market prices. One would therefore expect private equity to underperform public equity during bull markets and outperform in bear markets. It can be argued that this is somewhat artificial. It might be more accurate to compare the performance of private equity to the change in the book values of public companies instead of their market prices. However, these differences tend to even out in the long run.
Comparisons of public and private equity returns tend to be more accurate over longer time frames.
Drawbacks of Private Equity
Although private equity can be a lucrative investment option for high-net-worth individuals, it is not the only alternative asset class that provides attractive returns. Investors interested in private equity, venture capital, or other alternatives should be aware that their potential for higher returns also comes with higher risk. A high degree of risk tolerance and the ability to handle substantial illiquidity are necessary for success in private equity markets. In some cases, it can take a year or more to sell investments in private equity.
FAQs
Key Takeaways
How is private equity different from other investments? ›
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.
Does private equity have higher returns? ›
Public equity refers to ownership in publicly traded companies, which are available to anyone with an investment account. Private equity has historically higher returns but isn't available to everyone and has downsides that include higher risk, higher fees, and lower liquidity.
What is the rate of return on private equity? ›
According toCambridge Associates' U.S. Private Equity Index, PE had an average annual return of 14.65% in the 20 years ended December 31,2021.
Do private equity funds outperform the market? ›
You may be aware of the longstanding question about whether private equity returns have historically outperformed public equity. The simple answer is: yes, by a significant margin.
How does private equity investing compare with public market investing what are the similarities and differences between the two? ›
Public investors build wealth by accumulating stocks. By contrast, private equity investors get paid through distributions. Since investors who invest in public stocks can easily trade shares on public exchanges, they have the advantage of liquidity over private equity investment.
What is the difference between public equity and private equity returns? ›
Private vs public - the Net Return question
When allowing for cash flow differences by using a technique called a public market equivalent (PME) and drawing comparisons between public equities and the relevant types of PE funds, the results indicate that private equity has historically outperformed public equity.
How to evaluate private equity returns? ›
Performance in private equity investing can be measured using the internal rate of return (IRR), the multiple of money (MoM), and the public market equivalent (PME).
Is private equity really better than investment banking? ›
So, if you're interested in finance and deal-making, investment banking is the way to go. If you're more interested in strategy and operations, private equity might be a better fit.
What is the 2 20 rule in private equity? ›
The 2 and 20 is a hedge fund compensation structure consisting of a management fee and a performance fee. 2% represents a management fee which is applied to the total assets under management. A 20% performance fee is charged on the profits that the hedge fund generates, beyond a specified minimum threshold.
The annualized standard deviation of returns for private equity equaled 15.8% for the 22-year period, compared to 17.5% for public stocks.
What fees do private equity firms charge? ›
What you should know:
| Calculation | % of Committed Capital, Net Asset Value or Profit |
|---|
| Net Invested Capital Fee | Following the initial investment period, management fees are customarily based on net invested capital. | 0.09% - 2.25% |
| Carried Interest | A fee calculated as a percentage of profits above the hurdle rate. | 8% |
1 more rowFor unlevered deals, commercial real estate investors today are generally targeting IRR values of somewhere between about 6% and 11% for five to ten year hold periods, with lower-risk deals with a longer projected hold period on the lower end of that spectrum, and higher-risk deals with a shorter projected hold period ...
Does private equity outperform the S&P 500? ›
In years in which the S&P 500 gained more than 15 percent, PE funds only generated an average excess return of 0.7 percent. But in years in which the S&P 500 lost more than 5 percent, PE funds beat their public market counterparts by 7.5 percent.
Does private equity do well in a recession? ›
Private equity can be a very well-performing asset class during a recession. By understanding the risks and opportunities and having the right processes and technologies in place, your firm can punch above its weight and deliver high-quality returns to its LPs.
What are the cons of private equity? ›
What are the cons of private equity investing? Private equity investments are illiquid: Investor's funds are locked for a certain period. As such, investors in private equity must have a long-term investment horizon and be willing to hold their investments for a few years, if not more.
What is the difference between investment and private investment? ›
Private equity is an alternative investment class that invests in or acquires private companies that are not listed on a public stock exchange. An investment company is a corporation or trust engaged in the business of investing the pooled capital of investors in financial securities.
Why is private equity better than investment banking? ›
However, investment bankers tend to work longer hours, often working late into the night and on weekends. Private equity firms also tend to have a more relaxed work environment and offer more flexible hours. So, if you're looking for a career with less hours commitment, private equity may be the way to go.
What is the difference between a private fund and an investment company? ›
Private funds differ from registered investment companies in that they are offered only to a limited number of financially sophisticated investors rather than to the general public.
What is the downside of private equity investment? ›
Higher risk: Private equity investments often involve significant risks, including the potential loss of your entire investment, which must be part of the individual investors' consideration process.
