With forecasts predicting modest returns from publicly traded stocks and bonds, investors are increasingly looking to private investments to diversify their portfolios and help achieve their return objectives.

Investments in private equity (PE), private credit, and real assets, however, come with additional complexities and risks not found in their public counterparts. That’s why it’s important to fully understand the unique risks of private investments as well as their potential benefits before making decisions about whether or not to include them in your portfolio.

This article covers the following:

• What are private investments?
• Things to know when considering private investments
• What is the difference between an accredited investor and a qualified purchaser?
• Private investment strategies
• What role do private investments play in a portfolio?
• Factors when considering private investments versus public investments

What Are Private Investments?

Private investments are assets outside of publicly traded stocks and bonds, and primarily fall into one of three categories:

• Private credit
• Private equity (PE)
• Real assets

Private investments are subject to regulatory requirements that identify investor requirements and the processes used for finding and approving investors. 

Private Credit

Private credit or private debt is the provision of debt financing to companies from sources other than banks or public markets. These sources typically include debt financing from funds or private lenders. Private debt has expanded significantly since the mid-2000s, seeing its largest boost from the increased regulatory environment for banks post-Great Financial Crisis (GFC).

Private credit often takes the form of loans, and are often compared to traditional publicly traded bonds, which can mean shorter duration and floating interest rates.

Examples of private credit include:

• Direct corporate lending. Lenders other than banks making loans to companies without traditional intermediaries. Commonly mid-market companies. This type of debt is typically at the top of the capital structure.
• Mezzanine. Hybrid debt issuance, subordinate to traditional debt but senior to equity. One of the riskiest forms of debt, usually carries an option to convert to equity and some of the highest yields.
• Distressed debt. Securities of a company that may have defaulted, declared bankruptcy or is experiencing another type of severe financial stress. Can consist of various financial instruments issued by a company that are trading at a significant discount and wider yields than the industry average. This is also considered a highly risky form of debt.
• Specialty financing. Lenders other than banks making loans to nontraditional businesses or individuals with nontraditional assets. Underwriting at banks is fairly rigid and relies on fairly binary analysis of risks. This type of debt allows hard-to-price assets to be used as collateral and offers a more tailored approach for borrowers with different needs.

Investors with appropriate risk tolerance can benefit from higher credit spreads—meaning the opportunity to obtain a higher yield on a riskier security that has the same maturity as lower-risk securities.

Private credit can also see positive results or at least avoid negative returns from rising interest rates during times of inflation as yields move higher due to economic tightening brought on by central banks. In contrast to traditional bonds with fixed interest rates, a vast majority of private credit is floating rate. As central banks raise benchmark rates, the floating component of private credit instruments rises in tandem and can offer real time interest rate protection.

Private credit is typically accessed via diversified private debt funds, each of which can operate in different levels of risk depending on the debt structure, repayment priority and underlying industry.

Private Equity (PE)

This is capital investment made into companies that are not publicly traded. The most common types of PE include:

• Venture capital (VC). Early-stage investment, often in companies that aren’t currently profitable. VC investments have a higher expected rate of return but significantly higher risk and likelihood of loss of investment.
• Growth equity (GE). Strategic investment in private companies, more mature than early stage, could be looking to grow as a whole or specific market area, product innovation or internal operating unit.
• Leveraged buyouts (LBO). PE firm or firms taking majority positions in companies along with debt financing, looking to control and improve or turnaround opportunistic businesses with expectation of a future sale for profit.

Real Assets

Real assets commonly refer to the following:

• Commercial and residential real estate
• Natural resources such as energy, or commodities from the timber and farming industries
• Investments in infrastructure projects

Real assets can be structured along a broad risk spectrum, ranging from opportunistic project-based investments with higher risk, to tenured assets with a total return and income-based profile. Real assets historically have lent themselves to being inflation hedges, due to their place in the economy as largely necessary providers of goods and use assets.

Publicly traded alternatives such as energy companies, real estate investment trusts, and public commodity companies can act as a proxy for private real assets, however they tend to have a significantly higher correlation to public equity markets than their specific industries. Inclusion within major stock indices and investor behavior treating these asset classes in tandem with stocks leads to stock-like behavior.

As with other private investments, private real assets give an investor an opportunity to diversify within specific asset classes and niche industries beyond what is offered in public markets.

Key Characteristics of Private Investments

Although private investments may resemble public investments, there are several significant differences in their characteristics that potential investors need to know.

Illiquidity

The illiquidity of private investments can be a benefit as it allows for the underlying investment and business to perform without disruption by short term events, performance demands or volatility fears from investors. Overall, they are influenced differently by market circumstances than traditional investments like stocks and bonds.

Conversely, private investments have no ready market and there are regulatory restrictions on re-sale. This means they generally cannot be sold and should be considered long-term holdings. Investors need to be comfortable with this lack of liquidity, or plan for sourcing liquidity needs from active income or other areas of their portfolio.

Additionally, many private investments have restrictions on the ability of investors to transfer their fund interests to other persons, which can be challenging in estate transfer situations. Specific considerations would need to be made for inheritors who may be unfamiliar with private investments and their characteristics.

Uncorrelated or Low Correlation to Traditional Investments

Liquidity in public markets means a constant reassessment of how assets are priced. This leads to increased volatility and highly reactionary movements based on economic events.

Private investments, on the other hand, feature infrequent, or virtually non-existent, pricing and illiquidity, resulting in traditionally less volatility and lower correlation to public markets.

Higher Return Potential

Private investments involve a number of risks, including illiquidity, lower transparency and less regulatory oversight than is found in public securities. They are also frequently early-stage or involve untested business models and management teams.

Because of the inherently greater risk, private investments generally offer a greater potential return or risk premium. There is also greater opportunity for inefficiencies in private markets given lack of liquidity and funding availability.

Complex Fee Structure and Risk-Return Profile

Investment or fund sponsors have more leeway on fee structure due to sourcing, sophistication, and monitoring of underlying investments. These can include higher assets under management (AUM) fees, performance-based fees, and specific return hurdles.

Higher Minimum Investment

Due to the regulatory and logistical structure of private investments, significantly higher minimums are required—$100,000 on average. Certain funds have regulations that require a maximum number of investors.

Private investments require the understanding, experience and planning to properly implement within an investment portfolio and financial plan. Risk-return expectations, proper exposure to various asset classes and planning for liquidity from elsewhere lie at the base of properly deploying capital into private investments.

Things to Know When Considering Private Investments

Private investments can vary across a similar risk spectrum but require investors to meet the specific standards of the SEC, and sometimes, those of the state regulators. Those standards are based on net worth, income, investment acumen, and other factors, and are largely determined by the exemption from registration the private issuer has chosen to use.

Private investments are not the right choice for every investor. Their unique risk profile and complex investment characteristics make them more suitable for investors who have considered these factors, including the following.

High Minimum Investment Requirements

Given the higher minimums, an investor needs to take into consideration how much a particular private investment or fund makes up within their portfolio to avoid concentration risk.

Extended Time Horizon

Along with the illiquidity inherent in private investments, investors need to plan for a lack of immediate return of capital and longer timeframes to recoup an initial investment, in addition to the increased risk of outright loss of investment. Planning for and sourcing liquidity needs from active income or other areas of the portfolio is imperative when considering private investments.

Risk Profile

Similar to the most prominent public asset classes of stocks and bonds, private investments carry different risk and return expectations, income streams and correlation to other investments.

Investors need to take these into consideration depending on their investment objectives, individual tax situation, risk tolerance and long term financial and estate plan.

What Is the Difference Between an Accredited Investor and a Qualified Purchaser?

There is a perception that private investments are only available to investors and institutions with very large portfolios. In truth, there is a broad array of investment opportunities in the private space that may appeal to different types of investors.

In general, investors must be at least accredited investors to invest in private securities. However, there are also private funds that may restrict investment to those who qualify as both an accredited investor and a qualified purchaser.

Accredited investors are individuals who meet one of the following financial criteria:

• Net worth exceeding $1 million, excluding the value of a primary residence, either individually or jointly with a spouse
• Household annual income of over $200,000 for past two years for an individual or $300,000 for a couple with the expectation of the same or greater income level in the current year

Qualified purchasers meet a higher threshold under the following criteria:

• Individuals, couples, or estate-planning entities with more than $5 million in investment value, excluding primary residence and business property
• Certain groups, such as companies and investment managers with more than $25 million invested for their own accounts or on behalf of other investors; entities can’t be created for the sole purpose of investing in a specific asset or fund

Accredited investors or entities that also meet the qualified purchaser standard can invest in a broader array of private investments that may be structured more preferably than those open to generally to accredited investors.

Private Investment Strategies

The increased availability of private investments, through advisors, private investment-specific platforms and broker dealers, has made investing more accessible. To mitigate risk, it’s still imperative that investors understand the various private investment asset classes, structures, vehicles and how to implement them in a portfolio strategy.

Exposure to private investments has been gaining momentum among investors with $5 million or more in investable assets—7.7% allocation to alternatives in 2020 increased to 9.1% by the end of 2022, and is likely to keep increasing, according to The Cerulli Report – US High-Net-Worth and Ultra-High-Net-Worth Markets 2022.

What Role Do Private Investments Play in a Portfolio?

Private investments can create the following potential results in a portfolio:

• Enhanced return and income potential
• Broader diversification
• Lower correlation
• Larger opportunity set
• Decreased liquidity
• Potential for greater or complete loss of capital

Enhanced Return and Income Potential

Private Credit

Floating rate means higher income during higher inflation; shorter duration lends itself to some protection from duration risk and rates rising which hurt long duration assets. Allocation to leveraged loans, smaller companies, different variations of seniority or debt structure, and illiquidity equates to higher risk premiums than public market.

Private Equity (PE)

PE can be less concentrated, giving it a higher probability of dislocation, and the ability to generate a competitive advantage in inefficient markets. Executives are not being compensated for short term stock price so longer-term initiatives can be implemented by leadership without short term performance driving decision making.

PE offers access to industries that may not exist in public markets, or companies that are in their infancy, offering higher potential expected return if they survive. Higher risk PE such as VC can be extremely variable compared to more tenured PE investments.

Real Assets

This allows investors growth and income potential using inflation as a hedge; as goods prices inflate so does revenue. This removes the correlation of public commodity and real estate investment trust (REIT) investments that tend to behave like stocks.

Private real assets can reflect the actual asset and asset class and not the stock market at large. Certain real asset investment income can have preferential tax treatment dependent on the structure of the investment.

Broader Diversification

Increased market cap concentration and acquisition has led to less diversification within public markets over the past 20 years. Private markets, conversely, have grown significantly during this same time period, and as a result, now offer a broader array of business sectors and industries in which to invest.

Lower Correlation

In line with a broader array of company sectors and industries comes less correlation to other investments, specifically public markets. The illiquid nature of private investments leads to lower correlation to short term economic or geopolitical events, market volatility, and finite performance-based measures by company leadership.

Factors When Considering Private Investments Versus Public Investments

It’s important to consider the following when exploring private investments:

• Liquidity
• Risk tolerance
• Allocation
• Method of exposure
• Allocation over time
• Longer terms
• Economic cycles

Liquidity

Appropriate liquidity planning is imperative. Whether a client is in the savings or consumption phase, it’s important to consider whether there are other resources within your portfolio that provide ongoing retirement income and larger liquidity for planned goals.

Additionally, potential cashflows from private investments can enhance and diversify other sources of income.

Risk Tolerance

Like assessing volatility in a public portfolio, private investment asset classes carry risk characteristics that can vary drastically and aren’t appropriate for every investor or stage in their financial life.

Public investments are typically liquid, even if the timing may not be ideal when holdings must be sold on short notice because funds are needed. In contrast, private investments tend to be truly illiquid or can carry significant redemption costs if cash is needed.

Allocation

Due to their illiquidity, an investor should review overall allocation to private investments, as well as exposure to the underlying asset classes, in light of their total portfolio.

Just like in a traditional public portfolio, concentration risk from an individual company to a sector or asset class needs to be assessed.

Method of Exposure

Certain methods of exposure lend themselves to different asset classes more effectively than others. The three primary methods of exposure are single investment, fund, and fund of funds.

• Single investments can lead to concentration risk, and also tend to require additional due diligence and allocation management.
• Funds can provide easier access, increased diversification, and less monitoring, but also may come with higher fee structures.
• Funds of funds can go a step further with increased diversification across different managers and vintages, however they come with another layer of fees.

Allocation Over Time

Most public investments can be made at nearly any time the market is open. In contrast, private investments are made at significantly less frequent intervals. Evergreen funds accept new investors on a consistent periodic basis, whereas closed-end funds typically raise investor interest and capital for a finite period.

Planning for investment into either type depends on the underlying asset class, existing private investment exposure, and timing cash flows for future capital calls. Planning strategically and allocating over time can decrease vintage risk and cash drag on an investor’s portfolio, two prominent risks in private investments.

Longer-Term Taxation

Terms of investment and cash flows, estate planning and gifting may be longer with private investments, and can be taxed differently depending on the structure of the investment, account placement, and types of distributions from the investment.

Illiquid investments can create estate planning issues if there’s a lack of coordination with your financial and estate plan. Certain private investments can also create opportunities for efficient estate planning and gifting if planned and in coordination with other investment assets.

Economic Cycles

Allocations in this space may be ongoing, cyclical, or opportunistic. Similar to public markets, certain asset classes and funds within private investments will frequently be positioned as core investments within a private allocation that can be allocated to on a consistent basis.

On the contrary, certain times within economic cycles or during exogenous events can present opportunities that may be allocated to in a less frequent or one-off basis given an underlying investment thesis that may be seizing on a short term window.

We’re Here to Help

For more information about incorporating private investments into a portfolio reach out to your Moss Adams professional.

Additional Resources

• Private Clients Practice
• Individual Investment Services