Here’s what we cover in this episode:
⚖️ Key differences: Private vs. Public investments
⚠️ Illiquidity and higher fees are key risks
💰 Return potential: Why consider private investments
🧭Access and barriers to private investments
Executive Summary:
The investment landscape for retirees is evolving beyond traditional stock and bond investments. Private investments are investments that are not publicly traded. Until recently, access to these investments was largely limited to large institutional investors, such as pension funds, and ultra-high net worth individuals. Now, private investments are increasingly available to retirees.
Private investments are often sold with the promise of high returns and little risk. However, adding private investments to a portfolio without due diligence, or with inadequate risk controls, may do more harm than good.
This guide will outline the benefits and risks of private investments and explain their potential role in a retiree’s long-term investment strategy.
Defining Private vs. Public Investments
Private and public investments primarily differ in how they are bought and sold.
Public Investments: Traditional stock and bond investments trade on exchanges. They are liquid—meaning they can usually be bought and sold at prices at or very near current quoted market prices. Market prices are, of course, determined continuously by supply and demand.
Private Investments: These assets do not trade on exchanges. They are typically bought and sold in negotiated transactions, similar to how real estate is bought and sold. Beyond that, however, most of these investments boil down to stocks, bonds and real estate. An individual will typically access private assets through a fund that invests in a portfolio of these investments.
Private Investments as “Alternative Investments”
Private investments are often referred to as alternative investments. Broadly defined, alternative investments are asset classes outside publicly traded stocks and bonds. The “alternative” aspect of private investments is their illiquidity. Illiquidity provides certain benefits but also has drawbacks.
Other alternative investments include commodities, real estate, gold, and certain complex trading strategies such as statistical arbitrage. We will not fall down the alternative asset rabbit hole here! Our focus will remain on private investments.
The Case for Private Investments in Retirement
Private investments may benefit a properly constructed portfolio. They expand the investor’s opportunity set, and may both enhance returns and reduce portfolio volatility.
Expanded Opportunity Set
The available universe of investment opportunities has shifted dramatically over the past few decades. In 1996, there were over 8,000 listed companies in the United States. Today, that number is roughly halved, sitting around 4,000. This decline is a result of various factors, including mergers, acquisitions, and bankruptcies.
Conversely, the market for private companies, particularly those backed by private equity firms, has exploded. In the U.S. alone, there are an estimated 11,000 such companies, with over 200,000 globally. By limiting a portfolio strictly to public markets, investors exclude themselves from this vast and growing opportunity set.
Enhanced Return Potential
Historically, certain categories of private investments, most notably private equity, have delivered better returns than their public equity counterparts. This performance gap can be attributed to several structural advantages inherent to the private market:
- Lower Valuations: Private companies are frequently acquired at lower valuations compared to publicly traded peers. Purchasing assets at a discount, all else being equal, sets the stage for potentially higher long-term returns.
- Strategic Use of Leverage: Private equity firms often employ structured leverage (debt) within their operating companies. While this can amplify risk, it also provides a mechanism to boost equity returns.
- Longer-Term Focus and Operational Improvement: Without the pressure of quarterly earnings reports and the short-term focus of public market analysts, private companies can pursue long-term operational efficiencies and strategic improvements. This ability to think long-term may be a significant source of value creation.
It’s important to note that investors don’t automatically earn these benefits by virtue of owning illiquid things. Private market investors may still overpay for assets, misuse leverage, and steer companies toward operational missteps. Sound execution is required to earn enhanced returns!
Portfolio Stability and Diversification
Illiquidity can introduce welcome stability into a retiree’s portfolio. Since private assets trade infrequently, their prices generally do not swing as frequently or as wildly as publicly traded securities. Private assets tend to “feel” more stable.
- Less Volatility: Private assets are typically valued monthly or quarterly using appraisals and recent transaction data, leading to smoother, less volatile price movements than public assets. This can be particularly beneficial to retirees who suffer significant stress from investment volatility. Smoother returns may reduce stress and help them make fewer emotional investment decisions.
- Diversification Benefits: Adding private investments can lower the correlation of the overall portfolio to the public markets. This provides a measurable diversification benefit, reducing overall portfolio volatility without necessarily sacrificing return potential.
The higher expected return associated with private market investments is called the illiquidity premium. This represents the additional return investors should demand as compensation for restricting ready access to their capital, all else equal. “All else equal” is doing some heavy lifting there! As mentioned above, the illiquidity premium is not some automatic benefit you get just for owning illiquid things. Earning an illiquidity premium requires a sound, well-executed investment strategy. A private market investor must still own good investments at reasonable prices.
Understanding the Risks and Drawbacks
No investment is without risk. For private investments, illiquidity is the most important to understand. However, private investments also involve greater complexity and less transparency than many retirees are accustomed to.
Illiquidity: The Primary Constraint
The most critical risk is illiquidity. Capital committed to a private investment can be tied up for extended periods—five years, a decade, even indefinitely. This is particularly true of venture capital investments and deep value private equity strategies focused on business turnarounds. Additionally, when private investments go poorly, they tend to take even longer to monetize than originally planned. Simply selling a disappointing private investment is usually not an option.
Thus, sound portfolio construction is critical for retiree portfolios using private investments. The overall portfolio must remain liquid enough to meet the retiree’s income needs, even if the private investments remain locked up for extended periods. Locking up too much capital in private assets invites catastrophe.
Higher Costs and Complexity
Private investment strategies are inherently more complex and, consequently, carry higher fees than traditional retirement investments. The complexity arises from active management, sophisticated deal sourcing, operational restructuring of portfolio companies, and advanced due diligence. Investors must carefully evaluate whether expected returns justify the cost. There is an old investor saying: I can’t eat gross returns! Net-of-fee returns are what matter.
Valuation and Transparency
Unlike publicly traded stocks with quoted market prices, private investments are not marked-to-market daily. Investment and fund values are estimated.
- Appraisal-Based Valuation: Portfolio assets are valued periodically using appraisals, similar to real estate, or by reference to recent similar transactions. These valuations may not perfectly reflect the prices at which assets could actually be sold at any given time.
- Less Transparency: Private companies are not subject to the same rigorous and frequent reporting requirements as public companies. This can make it more difficult to understand their financial health.
Suitability: Fitting Private Investments into a Retirement Plan
Private investments should not enter a retiree portfolio without detailed financial analysis. The suitability of these investments depends largely on a retiree’s goals and financial circumstances.
The Financial Planning Mandate
The decision to allocate capital to private markets must begin with a comprehensive financial plan. This plan establishes a retiree’s required long-term return, risk tolerance, and, most importantly, year-over-year liquidity needs. A portfolio must first be allocated to cover cash flow needs with liquid assets. Excess capital can then be used to pursue illiquid investment opportunities.
As a general guideline, many conservative wealth management models suggest keeping private market exposure under 20% of the total portfolio. This ensures most of the capital remains readily accessible.
Behavioral and Lifecycle Factors
- Willingness to Endure Tracking Error: Investors must be comfortable with the concept of tracking error, which measures how closely a fund’s performance tracks a benchmark. For example, if private investments underperform the S&P 500 during a given period, the investor must maintain conviction in the long-term strategy and avoid making emotional sell decisions. Selling underperforming private investments may not even be possible!
- Age and Estate Planning: Any allocation to illiquid assets should be tapered toward the later stages of retirement. Upon death, illiquid assets can complicate and delay estate settlement and distributions to heirs. Likewise, illiquid assets may not be suitable for heirs depending on their own financial circumstances.
Access and Due Diligence
Accessing the highest quality private investments is not straightforward. This is a complex and evolving area of the investment landscape.
Regulatory Barriers to Entry
Investor access is often limited by regulation, which is intended to protect investors who lack the resources to withstand loss or the expertise to understand complexity.
Funds often require investors to meet certain net worth thresholds such as “accredited investor,” “qualified client,” and “qualified purchaser.” These require significant income or investable net worth.
The Role of the Advisor and Due Diligence
Given the complexity we have discussed, working with a qualified and competent financial advisor is paramount. An advisor acts as a due diligence guide, translating industry jargon into something comprehensible to normal human beings, and also vetting the vast array of private investment options.
Critical areas for due diligence include:
- Investment Strategy: Understanding how a fund intends to generate returns and how the investor’s capital will be eventually returned (e.g., through asset sales, IPOs, or income generation).
- Diversification: Evaluating the number and type of underlying assets (e.g., a fund holding 3,000 corporate debt issuers is inherently less risky than one holding a single private company).
- Liquidity Terms: Knowing the exact schedule for redemptions—if redemptions are permitted at all—and any potential restrictions on withdrawing capital during periods of market stress.
- Cost: Understanding all the potential costs of the investment. In addition to a management fee, some private funds may charge a performance fee on their returns. Certain funds may also charge investors acquisition and disposition fees when portfolio companies are bought and sold.
- Tax Reporting: Does the fund use the 1099 or the more complicated K-1? K-1s are used by limited partnerships. They may complicate and delay tax preparation.
It is important to thoroughly read and understand fund documents for private investments. Private fund structures, particularly limited partnerships, may contain non-standard terms impacting costs, risk, and return.
Fund Structures
Liquidity terms and tax reporting are largely dictated by a fund’s legal structure:
- Interval Funds: These are a common structure in the wealth management space. They are akin to mutual funds for private assets, offering scheduled redemption windows for liquidity (e.g., quarterly or semi-annually). This feature makes them preferable for many retirement portfolios. However, the funds retain the right to limit redemptions if too many investors try to exit at once. Total redemptions are usually capped at 5% of a fund’s value per quarter. In periods of severe market stress, redemptions may be suspended entirely.
- Limited Partnerships: The traditional private fund structure. Limited partnerships often require capital to be locked up for a private investment fund’s entire lifespan without any options for early withdrawals. They may offer certain tax benefits (such as passing through deductible operating losses to their investors). However, such benefits come at the cost of increased tax complexity.
It’s critically important to understand that while interval funds offer liquidity, they never guarantee it. In periods of poor fund performance or market stress, it may become impossible to redeem from these funds, regardless of redemption rights offered in normal circumstances.
Access Through Fiduciary RIAs
Access to high-quality private investment vehicles is often limited on retail brokerage platforms due to the compliance and liability risks associated with mass public access.
Independent Registered Investment Advisory (RIA) firms, such as Wyze Wealth Advisors, whose advisors operate under a strict fiduciary standard, are frequently preferred partners for high-quality fund sponsors. RIAs conduct thorough client suitability checks and educate clients on the risks, ensuring that inflows into the funds are appropriate. This grants independent RIAs access to a broader and often better-vetted selection of private funds that may not be available on larger, non-fiduciary brokerage platforms.
The Role of Private Assets in our All-Season Framework
When integrated into a comprehensive asset allocation framework, private investments can play an important role in enhancing portfolio risk and return characteristics across different economic environments.
Mitigating Interest Rate Risk with Private Debt
Private corporate debt tends to be floating rate. The interest rates adjust with the key interest rates in the economy. In periods of rising inflation and interest rates, fixed-rate bonds will decline in price due to their less attractive coupons. The rates on floating rate debt, meanwhile, adjust upward with rates. This shields the assets’ prices from the impact of rising rates while simultaneously increasing the income they generate. The overall effect is to improve bond portfolio performance in an economic environment where bonds struggle.
Generating Risk-Adjusted Returns with Private Equity
Private equity’s primary role in a portfolio is to enhance returns. Historically, private equity has out-returned publicly traded stocks due to the illiquidity premium discussed earlier. A private equity allocation may therefore increase long-term portfolio returns. At the same time, private equity’s smoothed volatility profile helps reduce portfolio risk.
Conclusion
Private investments are powerful and increasingly accessible tools for enhancing retiree portfolios. We utilize broadly diversified, relatively inexpensive interval funds for this purpose, across both private debt and private equity.
Private investments are not without drawbacks. Illiquidity is a source of both benefits and risk. We therefore ensure portfolios are liquid enough to meet client needs before adding private market exposure. We also work hard to educate clients on these new investments in meetings, through our podcast, and on this blog.
With proper due diligence, portfolio construction, and client education, private investments make a worthwhile addition to retiree portfolios.
Authors:
Ryan Wyatt, CFP®, CIMA®
Nick Lewandowski, CFA®, CFP®
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This communication is provided by Wyze Wealth Advisors LLC, a registered investment adviser. All material is for informational and educational purposes only and should not be considered personalized investment advice or a recommendation regarding any specific security, strategy, or product.
The assumptions and scenarios presented are illustrative and do not reflect actual investment results. Projections are based on current market conditions, which may change. Past performance is not indicative of, and does not guarantee, future results. All investments involve risk, including the potential loss of principal.
Investment decisions should be made based on an individual’s objectives, risk tolerance, time horizon, and financial circumstances. Additional information about our services, fees, and Form ADV Part 2A is available upon request.
