Private Equity Investments Might Work, But Not for Doctors

Investments in private equity are exciting. Because they aren’t available to everyone. They are not public. They are private. But are private equity investments actually good investments for doctors? That’s the real question.

Remember, the path to financial freedom for doctors is relatively simple. Just follow these 7 steps.

As a result, we don’t need to take on extra risks to achieve our financial goals.

The problem is that the formula I describe in the post above is not terribly exciting. In fact, it’s downright boring. And as more sexy investment options get introduced to us, our human nature can’t help but think, “How much more money could I make doing that?!” Unfortunately, when it comes to investing, you have more success the less you do. As counterintuitive as that is.

I digress a little bit here. However, the point is that some investments like these can seem tempting but ultimately as so “out there” that most responsible investors know to avoid them. But private equity investing can seem both tempting and also impossibly reasonable.

So again, we have to ask the question, is private equity a wise investments for doctors seeking financial freedom?

Why is private equity investing tempting?

It’s pretty straight forward.

Right now, out of all the business in the US, only about 1% trade publicly. This percentage plummets even more if we consider the whole world.

private equity investments doctors — *Do we even want to get in?!*

That means that there are tons and tons of companies that we could be investing in privately that we just don’t have access to through our retirement or taxable brokerage accounts.

There could be the next companies to go public and crush the market. And if we could get in on the ground floor, just image the returns our investment could generate.

It’s easy to see why private equity investments seem so attractive.

But what are the downsides?

This is always what we have to consider. And there are some serious downsides to private equity and the characteristics of its returns:

Minimal liquidity. Once you invest, your money is not readily accessible if needed or if the investment does poorly.
Lack of transparency. There are no regulations stating that the investment sponsors need to tell you what is actually going on with your investments. Because it’s private, not public.
No access to daily pricing. See above.
Extreme positive skewness in returns. The median private equity return is much lower than the mean return. This is due to the fact that there is a small possibly of a really big return (investing in the next Apple before it goes public) with a much, much greater change of a small or negative return (investing in companies that go bust).
High standard deviation of returns. The historical standard deviation of private equity returns is greater than 100%. In comparison, the standard of deviation for the S&P 500 is 20%. This high standard deviation significantly decreases the annualized returns from private equity compared to their arithmetic averages or mean. Again, small chance of huge return, high chance of small, no or negative returns.
Lack of broad diversification. More on this later.

With this background in place, let’s get back to the original question…

Are private equity investments good investments for doctors?

And to answer this, let’s look at some research.

In the 20-year period ending in June 2005, private equity returned 13.8%, outperforming the S&P 500 index by 2.6% annually.

But this isn’t really a fair comparison, right? Because private equity, as we desc robed above, carries far more risk than the S&P 500. So, let’s compare the returns over that time period with an index fund of similarly risky stocks – let’s say small-cap value stocks. Well, over that same period, small-cap value index funds returned 16%, outperforming private equity returns.

But wait, there’s more…

Private equity investments are done in stages.

Early stage investments are much more risky. Because the company you are investing in is young. So, there are higher fees involved but also greater risk of loss, in addition to greater potential returns if the investment does hit.

But middle or later stage investments in private equity have, on average, much lower returns than early stage investments. In fact, middle and later stage investments in private equity have lower returns than the S&P 500.

But even taken as a whole, private equity returns don’t outperform public options

Multiple studies including those from the University of Chicago, MIT, and Northwestern show that the average private equity fund, net of fees, provided returns similar to the public equities market.

And this is despite much greater risk in private equity investing. For example, one of these studies showed that the survival rate of private firms from 1952 to 1999 was only 34%. This equals a very high risk of total loss on private equity investments. And keep in mind, these studies took place during the dot-com era – one of the biggest private equity booms in history.

More recent studies demonstrate the same findings in terms of return comparisons between private and public equities.

Why private equity investments might still work, but not for doctors

Despite all of the troublesome characteristics and the data displayed above, private equity investments can still work, just not for individual investors like me and other doctors.

And here’s why.

I discussed above that private equity investments are limited by returns that exhibit huge positive skewness and massive standard deviations. I also mentioned that, for most of us, they exhibit another big problem – a lack of diversification.

As a result, private equity investors need to accept the risk that their investments likely will produce a wide range of returns. The net of these returns will likely underperform what is available publicly – namely total market index funds.

However, institutional investors are much more able to invest in private equity across a wide range of investments to provide the diversification that is missing for individual investors. Individual investors, even with access to funds of private equity investments, are highly unlikely to be able to do this due to a lack of capital of the magnitude necessary.

So, individual investors like doctors would not b e able to achieve even the not-risk-adjusted return of 13.8% listed above for all private equity investments.

The nail in the private equity coffin

The risk that individual investors like doctors take on with private equity investments is an uncompensated risk.

This means that it is a risk that investors are not compensated for. You do not get higher potential returns as a result of taking on this risk.

Why?

Because this risk could be diversified away.

As the saying goes, “No risk, no reward.” Well, in this case, it’s “Risk. And no reward.” And that’s a deal that no one should take.

Where do we end up?

Well, we end up back where we started.

The path to financial freedom is relatively simple. Follow these steps and build these simple financial habits.

But that doesn’t mean the path is easy. You need to create a written financial plan like mine and stick with it. Along the way there will be temptations, like private equity. But remember, once you have a plan to reach financial freedom, you don’t need to change it.

Just keep following and you will get there.

For more resources on how the stock market works and how you can invest in it successfully, check out these posts:

What do you think? Do you invest in private equity? If so, how? Do you experience the high dispersion of returns? Let us know in the comments below!