Alternative Investments: Private Equity Investing

Some investors incorrectly assume that all retirement accounts have restrictions on the investments that they can make. This inflexibility might be true for retirement accounts with a plan administrator who must follow certain investment rules. Self-directed retirement accounts do not have these rules.

Why do some employers’ retirement funds have limited investment options?

A 401(k) set up by a company that makes a matching contribution for employees may choose to have a plan that restricts the investment choices. The restrictions may only allow investments in publicly-traded stocks, bonds, mutual funds and exchange-traded funds (ETFs).

The plan’s rules may prohibit making a private equity investment. This rule may simplify the plan administration.

Self-Directed Retirement Accounts Have Fewer Restrictions

A self-directed retirement account does not have any such restrictions. The Internal Revenue Service (IRS) allows a self-directed retirement account to invest in private equity.

The investment categories for IRAs and self-directed accounts that are not allowed are investments in life insurance and collectibles. Collectibles include fine wines, liquor, art, antiques, coins, stamps, etc., with some exceptions under IRS section 408 (m).

Private Equity Investing

Private equity investing is an IRS-allowed alternative investment worth considering for self-directed retirement accounts.

Prohibited Transactions

When considering this alternative investment opportunity, be careful not to enter into a prohibited transaction with a disqualified person.

An example of a prohibited transaction is if you invest in a company owned by a family member using your self-directed retirement funds. That is a prohibited transaction with a disqualified person. Doing this would cause a tax event and having to pay the penalty on the money you withdrew from your retirement account.

How does private equity perform as an investment?

The New York Times reports that private equity typically outperforms publicly-traded stocks, especially if you include venture capital successes. Twenty years ago, private equity funds’ outperformance of the public market reached up to 15% higher. However, this better performance is not guaranteed.

The difference in performance between private and public equity is narrowing because of the huge amount of private equity money (estimated at $841 billion in 2021) sitting on the sidelines hunting for a deal. Profits are narrowing when so much money is chasing too few deals.

The American Investment Council reported as of Sep. 2020, for the previous decade, private equity funds produced a median of 14.2 % annualized return, net of fees, compared with 13.7% for the S&P 500.

However, public pension funds that invested in private equity funds only had a return of 12.8% (net of fees), which is a worse performance than an index fund of the S&P 500.

Watch Out for the Fees

Making an investment through your self-directed retirement account in a private equity fund may be worth considering for your investment strategy. However, a private equity investor should be cautious about the fee structures and read all the fine print in every detail.

In some cases, it turns out that some private equity performance may be exceptional. Nevertheless, the fund’s management fees may take such a whopping portion of the profits that the returns for the fund investors are modest.

The New York Times reports that there were 22 multibillionaires who were private equity fund managers in 2020, up from just three in 2005. Those billionaire managers took a considerable amount of the private equity funds’ profits.

Diversification

Not having any restrictions on your self-directed retirement account from making private equity investments allows for more diversification. You are free to allocate a portion of your investment portfolio to alternative investments that include private equity.

Due Diligence

In general, private equity investing requires making considerable effort in due diligence. You do this to uncover the same types of information found in the Securities and Exchange Commission (SEC) filings of publicly-traded companies.

The Long-Term Investment Horizon

Using a self-directed retirement account to make a private equity investment may have a long-term investment horizon. This opportunity depends on how many years remain until your retirement.

An illiquid private equity investment, which takes a long time to pay a return, is more suitable for a retirement account. It is reasonable to allow a long-term investment if there are decades before you need any of the funds.

Minimum Investment Requirements

It used to be that private equity funds were only available to the super-wealthy. Many private equity funds have a very high minimum investment threshold, such as $25 million for participation.

Now, there are private equity funds that have lowered their minimum investment requirement to only $25,000 making the opportunity more readily available.

Accredited Investor

Retail investors become more attracted to private equity when they have access to it. Nevertheless, it is still an asset class that requires an investor to be accredited.

An accredited investor must have a net worth of at least $1 million and have made $200,000 in yearly income individually ($300,000 with a spouse) for the past two years and expect this to continue.

You do not have to meet the financial requirements for accreditation if you become accredited through education by getting a Series 65 license.

For self-directed investors, accreditation is useful because of the possible investments for retirement funds. If you are young, with some retirement funds to work with, this may be a strategy to consider. When you are still working on your first million, achieving accreditation by getting your series 65 license is a viable option that may also help your career.