How to invest in the private market

Private investments can expose investors to new opportunities, but they also hold unique risks.

  • By Paulina Likos,
  • U.S. News & World Report
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Some of the best investment opportunities can be found outside of the public market.

The private market consists of alternative investments such as private equity, private lending, venture capital and private real assets. Private investment opportunities are growing rapidly and private market participants have been very active.

But the private market is not as accessible as the public market.

In the public market, companies listed on an exchange sell shares of company ownership in the form of a stock or other security. Companies in the private market, however, are not listed on a public stock exchange. These companies have either been around much longer with proven revenue track records or are startups that need capital for growth, usually provided by private equity firms, venture capital firms, hedge funds or other private market participants.

The private market has been experiencing significant growth. According to "McKinsey's Private Markets Annual Review," published in February 2020, private market assets under management grew $4 trillion, or 170%, within the last decade. Similarly, an increase of private equity firms that invest in existing private companies, or startups, followed.

With tech-enabled, consumer-focused businesses on the rise across industries, there are many global investment opportunities in the private market in a variety of different sectors. Channels of entry into the private market may not be as well-known to retail investors, but they are available. How can investors get skin in the game? Here's what you need to know before investing in the private market:

  • Private market characteristics
  • Accessing the private market
  • Private market investment risks
  • Investment options

Private market characteristics

Investing opportunities in private companies are usually available to investors who fall under the definition of accredited investor. An accredited investor is either a person or an entity qualified under the U.S. Securities and Exchange Commission's Rule 501of Regulation D, which outlines specific criteria for which investors can participate in the private market, such as income and net-worth requirements, professional qualifications and experiences, to name a few.

Investment returns in the private market historically have generated more than that of the public market. Examining the private equity segment of the private market, Cambridge Associates in a June 30 report shows that the US Private Equity Index had a 20-year return of 10.48%, compared with the S&P 500's (.SPX) 5.91% return during the same period. Comparing returns over a shorter time frame, the same report shows the US Private Equity Index's 10-year investment returns to be 13.77% versus the S&P 500's 13.99%.

Notably, there have been fewer companies going public and more choosing to stay private.

"In the year 2000, there were 8,000 publicly traded stocks, and today there's around 3,700. That's less than half of the available investment options to invest in publicly in 20 years," says Mitch Reiner, founding partner at Altera Investments, an alternative investment firm in Atlanta.

"If that trend continues, we need to be cognizant in how to invest in private markets because that's less opportunity which may mean greater efficiency in the market," Reiner explains.

The decline in the number of public companies can be attributed to fewer regulatory restrictions in the private market compared with the public market, which has SEC reporting requirements. This means private companies are not subject to disclose financial reporting typically seen with public companies. Moreover, given that there are several avenues for financing private companies coming from private equity or private credit funds, there is abundant liquidity in the private marketplace, giving private companies room for growth.

The influx of capital and fundraising dollars along with ongoing private market deals shows how investors see opportunities outside of public equity. Furthermore, investors observe that the value of private companies has been increasing. This motivates investors to get into these investments in the early stages of business development, having the potential to generate substantial returns for investors down the road.

Accessing the private market

While more individual investors can access and invest in the public market today, their access to the private market is not as widespread.

Since there are specific criteria under the accredited investor definition, it's usually the individual investor with a high net worth who can gain greater access to the private markets. Less access to private securities for the everyday investor means missed opportunities to invest in strong private companies that are still growing.

But with the SEC's Regulation A, companies can raise up to $75 million in equity investment opportunities from the public market without having to register the offering with the SEC.

Steven Weinstein, CEO at Seismic Capital in Los Angeles, explains how Regulation A makes investments available to those who don't have a lot of capital to invest in one transaction.

"It gives companies an opportunity to bring investors in who want to be investing in exciting startup opportunities but typically don't have the chance to do that," Weinstein says. "By opening their doors to retail investors, sometimes with minimum investments as low as $1,000, we're saying you don't have to be well-connected to be a part of these exciting opportunities."

Private market investment risks

Investing in private companies can be considered riskier than publicly traded companies in some respects.

Evaluating a private company is similar to researching a public company; however, the same tools and resources accessible for public companies may not be available for private companies. This is because they are not subject to reporting their business data to the public, a challenge for investors when it comes to assessing business value.

"The level of due diligence and the lengths you have to go to accomplish that due diligence is difficult, which is why there's a premium on returns in the private market," Reiner says.

A lack of financial reporting could pose challenges to investors who seek to do thorough research on a company. A private company's management that is not forthcoming with answers to investor questions may pose transparency concerns.

Raelan Lambert, global head of alternatives at Mercer, a global health career, retirement and investments consulting firm headquartered in New York City, says one of the ways to measure the performance of a private fund manager is by a peer-to-peer comparison.

"For all the other buyout managers that raised capital in a given vintage year, how does the manager I invested in and the returns they've generated compare to other buyout managers that raised capital within that cohort," Lambert explains.

"You want the peer comparison to have enough peers in it to be broadly representative of the opportunity set but also you want it to be somewhat more specific to the manager's strategy, target market and geography that you are looking to compare to other similar managers that raised capital," she says.

Another risk the private market has is its lack of liquidity. Unlike the stock market where you can easily buy and sell shares of a stock, private investments are illiquid, meaning they are assets that cannot be easily exchanged or sold for cash without a loss in value. Typically, you need to commit several years to the fund before you achieve your ultimate return.

When investors make the decision to commit, Lambert says they are typically locked up for 10 to 15 years, although investors will see distributions throughout the fund's life.

"As opposed to buying a public stock where 100% of your capital is drawn down at the time of the trade, in private markets, that capital is not drawn down 100% on day one, rather it is called over a four- to six-year period," Lambert explains.

If investors decide to back out it could be difficult to get that money back.

Investment options

If it's your first time investing in the private market, it can be challenging to invest in private securities. Seeking professional help can be a more favorable option. Experts recommend working with a fiduciary professional who has extensive experience with alternative investments.

"Engaging a trusted group of advisors to gain perspective from that acts as a board of advisors who are available for questions. It's important to look at a private deal and consider it relative to others," Reiner explains.

Investors can also choose publicly traded assets that give access to private markets. One exchange-traded fund that gives access to private equity is the Invesco Global Listed Private Equity ETF (PSP). PSP has a 10-year return of about 9.3%, with a net expense ratio of 1.58% and a market value of less than $14 per share.

PSP is known for its liquidity and is split between late-stage, midstage and early stage private equity. Other ETFs similar to PSP carry higher-than-normal fees, but these securities offer exposure to the private market, with diversification in multiple companies.

Despite its impressive growth, the private market has been lagging on efforts to improve diversity and inclusion. McKinsey's report explains that women and minorities continue to be underrepresented in private markets.

"Seismic is seeking out diversity and inclusion and ESG investments so that we're not just looking at the transaction that comes from ordinary sources," Weinstein says.

More specifically, Weinstein says he likes to look to incubators and accelerators that are sponsoring women entrepreneurs or entrepreneurs of color.

"It's sometimes not customary for people in those categories to find a place to pitch their deals or for them to feel comfortable in the room with the people making these investments," he says.

Momentum in the private market and its appeal of greater returns can be an attractive investment avenue, but for investors who are used to the public markets that are more liquid and have lower risk, the private market is a whole new ball game.

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