Private equity investing has long been outside the realm of
possibility for the average retail investor. Previously, one was required to be
an accredited investor in order to put money in private equity. The rule made
sense given the volatile hit-or-miss nature of PE; the individual
had to be able to afford the likely losses that would occur. The rare unicorn makes early stage investors
extraordinarily wealthy and these are the stories that make the headlines. The
fantasy of getting in early on a startup similar to Facebook, Snapchat, Uber, etc. is driving a
demand for PE investing for the average person. Currently, thanks
to websites such as Wefunder and StartEngine, the retail investor has access to
the dream of hitting it big.
These online private equity platforms for retail investors are
a bad place to put money for two reasons. The primary reason is that private
equity itself is better suited for an investor that is able to put many eggs in
many baskets. As I mentioned, investing in startups is extremely hit or miss.
Money needs to spread out in the hopes that the 10% of companies that hit more
than make up for the 90% of companies that miss. Investing a small amount as a
retail investor does not give you a broad enough brush, while investing more
could lead to unaffordable losses for a small investor when the 10% fail to hit.
The second reason is that the online private equity shops
that allow retail investors are not getting their pick of the litter when it comes
to the start-ups themselves. A start-up is more likely to go to a well
established venture capital firm that has the money and strategy to help them
grow, rather than a website that would just throw money at them. PE websites will be getting the leftovers, the start-ups that have been picked through ad
left behind, rather than the best of the best. This makes it even more likely
that a retail investor’s money will be picking a winner. It seems quite clear
that online PE is not the best choice for your money, however it is not hard to
see how a retail investor is able to justify an allocation of capital into an
online private equity fund.
I called it an allocation of capital because it really is
not an investment. Using the word investment to describe it just makes it
easier to justify putting money into it. If online PE is a sound investment,
then scratch-off tickets are an asset class. In the same way, it is easy to see
why one may rationalize a capital allocation into online PE. They hear the
stories of the millions and hope to hit it big too. It is the same concept of
buying a lottery ticket in hopes to hit the jackpot except they get to call it an investment. It is the desire to gamble and
to hit it big, the lack of patience in investing and the hype from the media
that drives people to put money into these unpromising funds. In the future
there will certainly be stories of the person who put half their 401(k) into
online PE and made millions. Conveniently left out are the majority of other
investors who lost more than they could afford.
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