Blackstone, Bridgewater Capital, Pershing Square, The Carlyle Group, Bain Capital. These are just some of the well known figures in private investments. These investment professionals are in the business of beating what public market returns can offer by using investor funds to exploit investment opportunities or market inefficiencies. In return, investors are rewarded with a share in the payout of these fund managers as they seek to generate higher and higher investment returns. While these managers typically seek the wealthiest individuals, endowment funds, pension funds, and foundations in society, there are many funds that have lower minimums that are accessible to non-institutional investors.
What are Private Investments?
These investment products are the introverted sibling to mutual funds. While mutual funds are commonly available to everyone for constant investment, private funds will raise funds and then close off the fund to new investors and aren’t listed on any public stock or bond markets. They start the same way as mutual funds with someone putting together an offering to take investors money and invest it in a unique way that should hopefully give both the manager and the investors a healthy return on their money.
Funds can be used to buy real estate, shares in public or private companies, financially restructure companies, purchase acres of land or farms, commodities or precious metals, the list goes on and on. Sometimes the purpose of the fund is to fix failing businesses or assets by taking them out of the public eye, fixing it up, and then revealing it as a new and improved business or asset. Other times the purpose is to make strategic equity or debt investments into start-ups to help them grow, this is known as venture capital. No matter the technique, the goal is typically the same: make more money than you invested.
How does this grow my passive income?
Just like mutual funds, these private funds also pay out dividends and capital gains while you are invested in the fund. However, because part of the return structure of the fund may be to sell the improved business or asset, there is a timeline to how long you can borrow the income that the fund will payout. These funds could be paying you for 6 months and then shut down or for the next 15 years before the fund ends. Depending on if this is an equity position or a debt position you are taking, that will determine the guaranteed or “preferred” return they can give you.
Successful managers who build a whole business around doing this may have multiple funds running at the same time. You can choose to take your distributions as a personal profit or, like mutual funds, reinvest them into the manager’s next fund or a different manager’s fund. This will allow you to create multiple streams of income in this lucrative, and at times very tax efficient, asset class.
Why would I want this passive income stream?
An interesting fact you may not be aware of is that the number of public companies, at least in the US, have been declining since the 90’s. Due to the difficulty of becoming a public company listed on a stock exchange, many companies are remaining private and getting the funding they need from private investors. That means there are less stocks today than before for us to invest in and grow our wealth. Many large companies, think Amazon, Google, Microsoft, Facebook, buy up smaller companies before they have a chance to go public. That means the only people profiting from those acquisitions are the private investors who funded the smaller companies. Private investments give you the opportunity to participate in those private transactions that you are currently excluded from.
Besides having a more holistic and diverse portfolio that includes both public and private companies, especially those who are into replicating the total market, buying into the private funds makes you a Limited Partner. The manager of the fund is considered the General Partner who oversees the fund, while your job as the Limited partner is to put money in the fund and receive both dividends and/or capital gains income, as well as losses. Yup, unlike the mutual fund, the manager can pass on losses to you as a Limited Partner.
Why the heck would you want to “receive” losses? Think about a business, when they have expenses or losses, they can deduct that against their income and are only taxed on what’s left over. Similarly, it’s possible to receive losses “on paper” that indicate the income you received should not be fully taxed if there are losses. Remember, it’s not about how much you make, it’s about how much money you get to keep!
Capital gains, as of 2022, are generally taxed between 0% and 20% versus dividends taxed at ordinary income or up to 37% depending on your tax bracket and account you invest with. If a fund sends you a lot of capital gains then this is one of the most tax efficient incomes there is. Likewise, if you receive passive paper losses that offset the income received, then you can work with your accountant to reduce your tax burden. The ultimate opportunity is when a fund distributes significant losses or depreciation to you, you can use the active-passive loss rule to potentially use the losses against other passive income streams and reduce your overall portfolio tax burden!
Risks and Considerations
Private funds have all the risks investing in a start-up company has. Illiquidity risk or not being able to access your money until the fund closes is a major hurdle for most people. There is manager risk, remember not all managers are right all the time and may not always outperform the stock market. There is a higher chance of either the manager or you getting audited by the IRS, especially since you both may be trying to go for maximum tax benefits.
Global or national economic factors that plague public markets can also affect private markets as well. You may not know the value of your private position throughout the year and there may be a few years of a negative valuation as the manager tries to add value to the asset.
Another major hurdle is that due to the complexity of these transactions, many mangers only want to deal with accredit investors or institutional investors who have a large net worth or wealth of experience to weather all the risks involved with their funds.
Greater due diligence is required on the part of the investor since all funds are not created equal. Each fund will have a prospectus, commonly called the Private Placement Memorandum (PPM), that will outline the opportunity and return structure for the investment. Depending on your financial sophistication, you may need to ask a lawyer, an accountant, or a financial advisor to read the PPM and help you assess if the opportunity makes sense for your strategic investments portfolio. The larger and more complicated your portfolio becomes, the more it makes sense to treat your investments as a business than a lone wolf operation or hobby. You may also consider getting asset protection by setting up legal entities such as LLCs or trusts to protect your investments if you personally, or the fund, experience any lawsuits.