A Closer Look at Alternative Investments: Private Equity

By Michael Williford, Spring 2016 Student Intern

I’ve talked before about alternative investments, and today I’ll turn my attention to another category, private equity. What is it? The term sounds exclusive and lucrative—because it is, and it can be, if you can tolerate the risk. The short answer is that there is no clear meaning, defined by the regulatory authorities, FINRA and the SEC. Generally, private equity investments are only available to wealthy individuals and institutional investors like pension funds, but the lessons private equity teaches are just as applicable to the average investor whose pension may be tied up in private equity investments.

The best example of how private equity works concerns a frim you almost certainly remember from the 2012 presidential campaign, Mitt Romney’s Bain Capital. In 2005, Bain Capital, along with Blackstone Group, managed a buyout of the arts and crafts chain, Michael’s. Bain and Blackstone turned a healthy profit on “scrapbookers and needlepoint artists,” but that hasn’t always been the case since the buyout. Like Bain, most private equity firms launched since 2005, have failed to beat the market.

One of the most important aspects of private equity investments to consider, like traditional investments, is the transparency with which a private equity firm discloses its fees. Many of the techniques used by Bain and Blackstone in the Michael’s deal are similar to those used by investment banks. The crucial difference, however, is that investment bankers are generally registered with FINRA as broker-dealers. “This lucrative status comes at a cost,” according to the New York Times. That cost is the regulation FINRA and the SEC impose on broker-dealers. Private Equity firms are not subject to any such restrictions. The net result is that an investor, be it a wealthy retiree or a pension fund, do not have access to the same information about the internal workings of a firm, its strategy, debt-load, or a clear picture of the kind of risk a firm’s investments entail.

The bottom-line for all alternative investments, whether it’s a Real Estate Investment Trust sold by a FINRA registered broker-dealer, or the rarified air of a Bain Capital private equity deal, is the same: Do your homework. Read the prospectus or any other offering materials associated with the investment. Those documents are supposed to disclose the extent of the risk your investment entails, and should things go sideways, they are the documents the broker will rely on to say the investor understood the full extent of the investment risk.