Surely you’ve heard someone advise you, “Don’t put all your eggs in one basket”?
This is great advice for any type of investing. But why don’t private equity investors diversify in this manner?
The fact is, the majority of individual private equity investors (“angel” investors) tend to under-diversify – they typically only invest in 1 or 2 companies. As a result, these investors increase their risk and decrease their potential for return on investment.
In other words, if you invest in only a handful of privately-held businesses, you are holding way too much risk. This all-too-common scenario should, and can be, be avoided.
Instead, investors can build a private equity portfolio that leverages the 20-year average returns of over 20.6% of early stage private equity investments (according to Thomson Financial/DowJones). Indeed, the only prudent approach to private equity investing is to invest through a portfolio of equity positions. If you do this correctly, this investing strategy allows you to leverage the return potential without the risk to principal that is so common in this class of investments.
How to Build a Private Equity Investment Portfolio
Of course, creating a private equity investment portfolio is easier said than done, especially for the individual investor. There are 3 common approaches, which all have their drawbacks:
Building a Portfolio One Investment at a Time
It’s possible to do this, though this should usually be left to the real “experts.” Stars like Vinod Khosla and Ron Conway have done this, with investments in hundreds of companies. At the same time, Khosla and Conway are professional technologists and investors who are deeply involved in the early stage deal community of Silicon Valley – unlike most individual investors.
Join an Angel Investment Network
More and more angel investing networks have been sprouting up in recent years, most centered around the dynamic innovation hubs of Silicon Valley, Boston, New York, Los Angeles and Austin. These typically involve groups of individual investors who come together to review deals as a group. There are benefits to this approach, including networking and spreading the costs of due diligence. However, most angel groups’ investment track records are mediocre as a result of “negative selection bias” as well as the high hurdle (and price) for entrepreneurs to gain access to review by these groups.
Become a Limited Partner in a Venture Capital Fund
The most respected firms (like Kleiner Perkins and Sequoia) are off-limits to the typical high-net-worth accredited investor. But there are hundreds of smaller venture capital and private equity funds that do accept investments in more modest amounts from individual investors. Some of them have good track records of success. However, the majority of these smaller funds focus on specific sectors, and therefore do not provide the sort of diversified “portfolio” approach that most investment advisors would recommend. In addition, these firms charge steep management fees that cut into investors’ profits.
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