As an investor, you may have heard of private market investments and wondered what they are and how they differ from the public markets.
By their nature, private market investments are harder to research, more difficult to access, and more complicated to own than their public market counterparts. Public market data like the returns of the S&P 500 are constantly the focus of the financial news media.
In recent years, new private investment fund structures emerged to provide a more accessible and streamlined investment process. Funds that historically required large investments with complicated tax reporting can now be purchased in increments as small as $2,500, while reporting taxes on your 1099 tax form from those investments is much easier today than five years ago. Investors can hold these investments within traditional brokerage accounts at custodians like Charles Schwab, Fidelity, etc.
In this blog post, I will provide a high-level overview of private market investments such as private equity, private credit, and private real estate, and will address these four questions.
What is a private market investment?
What types of private market investments are available?
How do investors gain access to private market investments?
What are the tax implications of private market investments?
A private market investment is a type of investment that is not traded publicly on the stock exchange. Simple, right? Basically, any investment that isn't public is private. Residential real estate, baseball cards, a pizza franchise, dental practice, etc.
The most common illustration of a private market investment is your residence if you own your home. There is no public exchange to buy or sell homes quickly and pricing is difficult to obtain without an appraisal or sale. Brokerage commissions can be high and closing documents can be hundreds of pages.
Provide access to unique investments that aren't available publicly. i.e., your home is one of a kind.
Limited pricing information compared to public market exchange information.
Typically, expensive to transact or own.
Not liquid. i.e., cannot easily convert to cash.
Requires a minimum level of net worth to participate.
Businesses, land, and rental properties are other examples of private investments.
Potential for higher returns.
Additional diversification beyond public assets.
Tax-efficient investments.
It is important to recognize that private market investments can be more risky than public market investments and should only be utilized after thorough analysis and due diligence.
Private credit funds are typically the lender of last resort for companies in need of quick cash. i.e., loan shark for companies.
Because some companies may be in need of the cash, investments in private credit funds can provide higher yields and often times better terms than public debt.
As of Q4 2023, private credit funds were yielding above 10% compared to 4.5% for the US bond index (Aggregate US bond index).
Investors should be aware of the risks associated with private credit investments, such as credit risk, illiquidity, and limited transparency. It's important to carefully evaluate the risks and benefits of private credit investments before investing in these funds.
Private real estate mutual funds are a type of private market investment that allow investors to pool their money with other investors to purchase real estate assets.
These funds are managed by professional investment managers who seek to generate returns for investors through rental income and property appreciation.
Private real estate funds are not traded on public exchanges like REITs. Instead, they are purchased or sold in a monthly or quarterly process. Typically, investors buy into the fund all at once but are restricted on cashing out. In one example fund, an investor could sell up to 5% of their investment per quarter.
Whereas the public REITs are valued each day, the private real estate fund may be valued each quarter or each month. The fund valuation is a combination of inputs from real estate professionals, cash flow projections, and investment managers.
Private real estate funds can have lower volatility than their public REIT counterparts. Private funds don't have to liquidate properties in a downturn because investors are restricted from selling. Private funds also value their properties on a long-term basis, so the values are less likely to swing than a public REIT price might in a market panic.
Private equity funds are a type of private market investment that involves investing in private companies. These funds aim to purchase shares of private companies, improve their operations, and sell them for a profit.
Private equity investments work like house flipping for businesses. They buy a company with the hope of generating a large profit in five years or less. The funds offer investors the potential for high returns, but they also come with high risk and require a longer investment horizon.
Private equity funds differ from publicly traded stocks in several ways. First, private equity funds are not traded on public exchanges, and therefore, they are not subject to the same regulatory requirements as publicly traded stocks. Additionally, private equity funds are only available to accredited investors who meet certain net worth and income requirements. The net worth requirements to purchase private equity investments are often much higher than private credit or private real estate (e.g., $2M or $5M net worth minimum).
One of the main benefits of investing in private equity funds is the potential for high returns. Private equity funds often invest in companies that have the potential for significant cash flow growth, and they use their expertise to help these companies achieve their goals. However, private equity funds also come with high risk, and not all investments will be successful.
Investors can gain access to private market investments through various channels. One way is through investment advisors or financial institutions that offer private market investment opportunities.
Some funds are set up to accept trades via online brokerage firms like Charles Schwab. Others require separate subscription agreements, attestations as to net worth, and signatures before investments can be added to a portfolio.
The recent innovation in the private fund industry is the ability to hold private investments within a traditional brokerage account and receive 1099 tax reporting similar to a public fund.
The term vintage is often used in wine to describe a particular year that a grape for that specific wine was grown, harvested, and vinted. Private funds have historically operated the same way in that investors invested in specific years (i.e., 2023 Private Equity Fund). Each year would have a different return based on the investments for that 'vintage'. Investors would need to reinvest each year in the new vintage to avoid missing a really good year.
The big innovation with the latest private funds is the ability to invest in an 'evergreen' fund. Essentially, an initial fund investment gives an investor an investment diversified across vintages without the ongoing need to sign new papers or fund successive investments.
Evergreen private funds reduce the risk you get a bad year (similar to wine) and provide for a less cumbersome investing experience.
When it comes to the tax treatment of private market investments, there are a few things to consider.
For example, would you rather pay income tax on a 10% dividend or receive the 10% tax free? If you are in the highest tax bracket, you might pick a tax-free Roth account to purchase the 10% yielding investment. If you are retired with low income, it might make sense to put the 10% yielding investment in your brokerage account and use the income for spending money.
Locating private market investments in an advantageous tax environment is important to your overall after-tax returns.
Another tax benefit of private market investments is the potential for tax efficient distributions. For example, if you invest in a private real estate fund that generates income from rental properties, your distribution may not be fully taxable. In one fund we have researched, a small portion of the distribution is actually taxable in the year it is received (i.e., a majority of the distribution is classified as return of capital which is not taxable when received). This can be a significant tax benefit for investors who are looking to maximize their after-tax returns in a traditional brokerage account.
On the other hand, private market investments can also come with some tax disadvantages. For example, private equity funds may require investors to pay taxes on "phantom income," which is income that is generated but not distributed to investors. This can create tax liabilities for investors even if they have not received any cash distributions.
Additionally, private market investments may be subject to higher tax rates than public market investments. This is because private market investments are often structured as partnerships, which can result in higher tax rates for investors. It's important to consult with a qualified tax advisor to understand the tax implications of investing in private markets.
In this post, we have explored the benefits and risks of investing in private market investments.
Overall, investing in private market investments can offer unique opportunities and potential for high returns, but it comes with higher risks and requires careful evaluation. By understanding the benefits, risks, and tax implications, investors can make informed decisions about incorporating private investments into their portfolios.
Disclosure
The views, opinions, and content presented herein are for informational and educational purposes only. They are not intended to reflect a current or past recommendation; investment, legal, tax, or accounting advice of any kind; or a solicitation of an offer to buy or sell any securities or investment services. Nothing presented should be considered to be an offer to provide any product or service in any jurisdiction that would be unlawful under the securities laws of that jurisdiction. Before taking any action, you should first consult with a financial professional.