Private Equity and Venture Capital Provide Diversification

Given that alternatives like private equity and venture capital behave differently than stocks and bonds, investing in them may provide broader diversification.

Generally speaking, alternative investments are an investment in assets other than stocks, bonds, and cash. Investment alternatives include venture capital, private equity and hedge funds, real estate investment trusts (REITs), commodities, as well as real assets such as art, wine, and unique jewelry.

Two of my favorite alternative investments are private equity, and venture capital investing.

Private equity firms typically raise funds and take capital from both non-institutional and institutional investors. These funds will then be used to place investments in promising private companies, or engage in buyouts of public companies which results in the unlisting of public equity. The capital is returned to investors upon an exit event such as an IPO or acquisition, after the firm takes its management and performance fee. One of the easiest ways for a small investor to get involved in private equity is to invest in the managers of private equity funds.

Venture capital is a subset of private equity specializing in the investment in early-stage to growth-stage companies. These companies are deemed to have high growth potential, or have demonstrated high growth — particularly with regards to annual revenue. Private equity firms will specialize in early stage investing, raising funds from high net worth and institutional investors and deploy the capital to companies ranging in industry, geography, and funding stages.

Although they sound strikingly similar, there are major differences in the way firms involved in private equity and venture capital do things. They buy different types and sizes of companies, they invest different amounts of money, and they claim different percentages of equity in the companies in which they invest.

In most instances, private equity firms invest in mature companies that have already established themselves. These companies may be deteriorating, or not making the profits they should, because of some area/s of inefficiency. Private equity firms buy these companies with the intention of streamlining operations to increase revenues. Venture capital firms, on the other hand, mostly invest in start-ups with high growth potential.

Given that alternative investments like private equity and venture capital tend to behave differently than stocks and bonds — and are generally less liquid than traditional investments, including them in a portfolio may provide broader diversification, reduce risk, and improve your investment returns.