How Private Equity Returns Stack Up to Other Investments
Private equity can generate higher returns than investments like stocks, bonds, or real estate, but it also carries risks such as illiquidity and long investment timelines. Comparing private equity with these other asset classes can help investors understand the potential benefits and challenges involved.
If you want to diversify your portfolio with private equity, a financial advisor can help you assess opportunities and manage risks.
How Private Equity Works
Private equity investing involves pooling capital from investors to acquire stakes in private companies, often to improve their value and eventually sell them for a profit. This type of investment is typically made by private equity firms using funds raised from institutional investors and high-net-worth individuals.
After acquiring a company, private equity firms work closely with management to implement operational improvements, strategic initiatives and sometimes restructuring efforts to enhance the company’s performance and value. This hands-on approach is a hallmark of private equity, as firms leverage their expertise and resources to drive growth and efficiency.
The ultimate goal of private equity is to exit the investment at a profit, typically within a three to seven-year timeframe. Exiting can be achieved through various exit strategies, such as selling the company to another firm, taking it public through an initial public offering (IPO), or recapitalizing it by selling a portion of the equity back to the market. Each exit strategy is carefully considered to maximize returns for the investors.
The success of a private equity investment is often measured by the internal rate of return (IRR), which reflects the annualized rate of growth an investment is expected to generate. By understanding how private equity works, investors can better appreciate the potential risks and rewards associated with this dynamic and influential sector of the financial industry.
How to Estimate Potential Returns for Private Equity
Estimating potential returns for private equity investments can be a complex endeavor compared to estimating the potential of other investments such as public equity, bonds and real estate. One primary difference is the impact of operational improvements private equity investors make to portfolio companies.
By enhancing efficiency, reducing costs, and driving revenue growth in the companies they own, private equity firms can significantly increase the value of their portfolios. Investors in bonds and public equity, by comparison, typically have little or no influence on how the companies are run. Real estate resembles private equity more closely in this regard, as investors may be responsible for personally managing properties they invest in.
Differences in Public vs. Private Equity Performance
Whether private equity appears more or less lucrative than other investments can depend on the period being measured as well as how and by whom the measuring is done. For example, in 2023 Cambridge Associates reported it had tracked nearly 1,500 private equity and venture capital partnerships over 25 years and found they returned 13.33% annually, well ahead of the 8.16% average annual return generated by the stocks in the Russell 3000.
Private equity shows up less well in other comparisons. For example, over a 10-year period from 2014 to 2024, the S&P Listed Private Equity Index returned approximately 7.4% per year. Meanwhile, the S&P 500 Index of large-capitalization publicly traded stocks returned an average of around 11% annually for the same period.
When private equity returns are compared to bonds and real estate, private equity generally comes out ahead. Like private equity, real estate investments are considered an alternative asset class, may be similarly long-term and illiquid and often use a structure similar to private equity investments. Bonds trade like public equity shares and are considered a basic asset class that provides stability and income to help manage portfolio risk.
In addition to generating different returns, private and public equity have other important distinguishing characteristics:
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Market accessibility: Public equity is traded on stock exchanges, making it accessible to a wide range of investors. Private equity involves investments in companies not listed on public exchanges, typically accessible only to accredited investors or institutional entities.
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Valuation methods: Public equity valuation often relies on market-based metrics such as stock price, market capitalization, and price-to-earnings ratios. Private equity valuation typically uses intrinsic valuation methods, including discounted cash flow analysis and comparable company analysis, due to the lack of market pricing.
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Transparency and regulation: Public companies are subject to stringent regulatory requirements and must disclose financial information regularly, providing transparency to investors. Private companies have fewer disclosure obligations, resulting in less transparency.
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Liquidity: Public equity offers high liquidity, allowing investors to buy and sell shares easily. Private equity investments are generally illiquid, with longer holding periods and more complex exit strategies.
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Valuation frequency: Public equity valuations fluctuate frequently with market conditions and investor sentiment.Private equity valuations are typically updated less frequently, often during funding rounds or significant corporate events.
Bottom Line
Understanding how private equity returns stack up to other investments helps investors seeking to diversify their portfolios. Private equity often offers potential for higher returns when compared with traditional investments like stocks and bonds. However, these potential rewards come with less liquidity, as private equity investments typically require a longer commitment and are not as easily traded as public equities.
Tips for Investment Planning
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A financial advisor can help you create a retirement plan based on your needs, goals and risk profile. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Whether you’re investing in private equity, public equity or another type of asset, you’ll want to know how much your portfolio could grow over time. SmartAsset’s investment calculator can give you an estimate.
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