Getting involved in investing may initially seem like a straightforward process. However, the topic quickly becomes more complicated, particularly when looking at investments in private equity. Alternative investments or alternative asset classes refer to any investments that go beyond the typical stocks, bonds, public funds (such as mutual funds and index funds) and cash. Private equity is one type of alternative investment asset class. For qualified investors, alternative investments can be a useful tool to diversify and enhance their portfolios.
Alternative investments, such as private equity, may be appropriate for qualified investors’ portfolios as their net worth begins to grow and they are seeking diversification from traditional asset classes. It is important to be aware of the different types of private equity investing.
Private companies can seek to take investor capital. The term “private equity” includes the entire investment spectrum of private capital markets. Investors can invest in private companies directly during asset-raising phases (see below), or investors can place capital with private equity firms, which raise money and take capital from non-institutional and institutional investors and invest directly with private companies in larger scale. Private equity firms heavily research private companies and place investments in only the most promising; investors then get their return in capital through an exit event (like an IPO) after the firm has already taken its management and performance fee (commonly referred to as carried interest).
Rather than placing capital with a private equity firm, investors also have the option to invest their money into a startup or private company directly. This style of investing directly into startups is often referred to as angel investing or venture capital (see below), and typically is more available during the earlier stages of a company’s growth. Direct investing can bring in high returns, but it is also very risky; most high net worth investors do not have the skill-set to thoroughly evaluate these private investments and many startups end up failing. Most private companies will seek investors through a private placement based upon specific valuations.
As mentioned above, venture capital is a subset of private equity that focuses on the investment in early-stage to growth-stage companies. Certain firms specialize in this type of early stage investing, raising capital from high net worth and institutional investors. Venture capital firms deploy capital to a wide variety of businesses that in different industries. These capital sources are critical for the startups and early-stage companies, as they may not have access to traditional financing due to a lack of extensive operational or revenue history. Venture capital is a higher-risk alternative investment, but have the potential to yield great returns. Examples would include Google, Facebook, and Twitter, but for every start-up company producing significant returns, there is a large multiple of failed companies. Venture capital investors need to be aware of the risks of investing in this particular asset class.