In this series on portfolio basics, I’ll explain some of the fundamentals of putting together sound portfolios. I’ll start with some of the most widely used types of investments and walk through what you need to know to use them effectively in a portfolio.
What Is Private Equity?
Private equity—a broad category that includes buyout funds, venture capital, and growth equity investments that don’t trade on an exchange and aren’t SEC-registered—is a popular hunting ground in the search for higher returns. US state pension funds have increased their private equity allocations to nearly 15% from 9% of total assets over the past five years. In 2020, the US Department of Labor issued guidance allowing 401(k) plans to include private equity investments as part of diversified investment options, such as target-date funds.
Another reason behind the growing interest in private equity: Companies are remaining private longer. The number of publicly traded companies in the United States has significantly declined over the past couple of decades. At the same time, the private market is home to about 1,400 unicorns—companies valued at $1 billion or more that are available only to select investors through private channels.
What Are the Advantages and Risks of Investing in Private Equity?
As the graph below illustrates, private equity has generated impressive returns over the past 24 years or so. Nearly every major private equity benchmark has generated returns well above those of the public equity market over that period. Since early 1999, the PitchBook PE All US Index has compounded returns by about 13.4% per year—surpassing the Morningstar US Market Index of publicly traded stocks by about 5 percentage points per year.
These impressive performance numbers require a couple of asterisks. For one thing, measuring returns for private equity is not straightforward. Private equity funds typically report returns using an internal-rate-of-return calculation that incorporates the beginning and ending values of the fund, as well as interim cash flows. One drawback to this method is that it assumes investors can reinvest any interim cash flows at the same rate of return, which is usually not the case. In contrast to total-return calculations that are compliant with global investment performance standards, internal rate of return does not have a single standard calculation method and can also be subject to manipulation by “gaming” the timing of cash flows.
In addition, reported IRR figures are subject to reporting lags due to the manual process of determining valuations on private companies, making it difficult to compare private-market assets and other parts of a portfolio in a timely fashion. On the venture capital side, IRR measures can also be heavily influenced by valuation levels at the time of exit. For example, many venture-funded firms were able to exit at steep valuations during 2020 and 2021.
Another caveat: Research has found a wide dispersion of returns for private equity versus their public counterparts. A recent report found an annualized return spread of as much as 16 percentage points per year for some types of private equity funds. Venture capital, in particular, tends to have a wide gap between the top and bottom performers. Out of every 10 investments, one or two might generate large gains, while the others return capital or fizzle out.
With those caveats in mind, private equity can generate attractive risk-adjusted returns. Over the trailing 20-year period from October 2004 through September 2024, several private equity subasset classes have generated both higher returns and lower risk than public equity markets. Real assets—defined as equity in areas such as infrastructure, oil and gas, timber, metals and mining, and agriculture—has had the highest volatility, while secondaries—which are pools of capital that invest in existing limited partnership interests or stakes in general partner-backed companies—has had the lowest.
Private equity has been subject to some degree of drawdown risk. Private real estate suffered a particularly bad stretch in the wake of the global financial crisis, when it shed about 56% of its value. The other private equity benchmarks have shown more modest levels of downside risk, although the actual level of risk is probably understated given the performance measurement issues discussed above. (Indeed, Cliff Asness has argued that the private equity industry is guilty of “volatility laundering.”)
How to Invest in Private Equity
There are several ways to invest in private equity. To gain access directly, investors must meet accredited investor requirements, which generally require annual income of at least $200,000 (or $300,000 joint income) for the two previous years as well the expectation that income will reach the same level in the current year. Investors can also be considered accredited investors if they have a net worth (either individually or with a spouse) of at least $1 million or have certain roles with the company issuing unregistered securities; that is, a private equity firm. Some private equity vehicles may require investors to meet qualified investor requirements, which require investment assets of at least $5 million.
Funds of funds offer more diversified exposure to private equity, but they also involve an additional layer of fees. The typical private equity fund of funds collects 1% in management fees and 5% in incentive compensation, which might seem low for private equity exposure, but those costs are in addition to the fees on the underlying funds.
Other Investment Options
For most individual investors, direct investment in private equity is likely out of reach. It typically requires a minimum direct investment of at least $1 million, and an investor would need closer to $20 million to create a diversified private equity portfolio. This effectively limits direct private equity exposure to an elite group of ultrawealthy individuals or family offices.
However, individuals at lower wealth levels now have other options for private equity exposure, including investing in a closed-end fund or exchange-traded offering. The table below shows some of the options available with relatively low investment minimums.
The ETFs shown above mainly focus on “listed private equity,” which are publicly traded companies that manage private equity funds. (Investors can’t simply buy an ETF consisting of private equities because ETFs and mutual funds aren’t permitted to invest more than 15% of their assets in illiquid securities.)
The closed-end funds, meanwhile, are often structured as interval funds or tender-offer funds. Interval funds typically allow investors to redeem 5% to 25% of their shares on a quarterly basis (with the specific amount specified by the board each quarter), while tender-offer funds may only allow periodic redemptions of up to 5% of an investor’s account. This lack of liquidity is one of the major negatives for many of the funds that are currently available to smaller investors.
Another major drawback: high expenses. As shown in the table, expense ratios for these funds are significantly higher than those of funds and ETFs that focus on public markets. That gives private equity funds a much bigger hurdle to overcome in generating returns.
How Long Should I Hold My Investments in Private Equity?
Based on Morningstar’s Role in Portfolio framework, I recommend holding any investments in private equity for at least 10 years. This guideline is partly based on looking at the historical frequency of losses over various rolling time periods ranging from one year to 10 years. Another consideration is the maximum time to recovery, or how long it usually takes to recover after a drawdown.
How Much of My Portfolio Should Be in Private Equity?
Looking at the market value of private equity relative to public equity is a reasonable starting point for answering this question. Based on data from Ocorian, US private equity assets totaled about $10.8 trillion as of the end of 2024, compared with $115.0 trillion for public equity. That would suggest an allocation of up to 9% of equity assets for US-based investors. But given private equity’s high cost and lack of liquidity, most investors will probably want to keep private equity allocations well below that number. Another reason to view private equity with a skeptical eye is that large investors generally get the pick of the litter when it comes to private-equity deals, potentially reducing the quality of offerings available to more mainstream investors.