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?
Remember, the path to financial freedom for doctors is relatively simple. As a result, we don’t need to take on extra risks to achieve our financial goals.
The problem is that my formula for financial freedom 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. While some types of investments can seem tempting, ultimately, 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 investment for doctors seeking financial freedom?
Why Is Private Equity Investing Tempting?
Right now, out of all the businesses in the U.S., only about 1% trade publicly. This percentage plummets even more if we consider the whole world.
But this still means 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.
Some of these companies could be the next big thing to go public and crush the market. And if we could get in on the ground floor, just imagine the returns our investment could generate.
It’s easy to see why private equity investments seem so attractive.
But what are the downsides?
- 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 possibility of a really big return (investing in the next Apple before it goes public) with a much, much greater chance 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 Smart Investments for Doctors?
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 described 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.
When taken as a whole, private equity returns don’t necessarily outperform public options.
Multiple studies suggest that the average private equity fund, net of fees, provide returns similar to the public equities market, or at the very least have been overestimated.
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% over the initial decade of the organization’s existence. This equals a very high risk of total loss on private equity investments. And keep in mind, this study took place, in part, during the dot-com era — one of the biggest private equity booms in history.
Why Private Equity Investments Might Still Work (Except 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 have a greater ability 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 necessary magnitude.
So, individual investors, like doctors, would not be able to achieve even the not-risk-adjusted return of 13.8% for all private equity investments.
The Nail in the Private Equity Coffin
The risk that individual investors 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.
Jordan Frey, MD, is a plastic surgeon at Erie County Medical Center in Buffalo, New York, and founder of The Prudent Plastic Surgeon.
Looking to improve your financial well-being? Check out Frey’s online course, Graduating to Success, a comprehensive and interactive 12-module course that helps doctors achieve personal, professional, and financial success during and after their transition from trainee to attending, or read his 2023 book, Money Matters in Medicine.
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