American Electric Power Employees: Private Equity

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For American Electric Power employees reaching retirement age, private equity presents exclusive opportunities to diversify investment portfolios, but comes with risks and long-term commitments, so a trusted advisor is essential for decision-making.' – Wesley Boudreaux, a representative of The Retirement Group, a division of Wealth Enhancement Group.

'Although private equity may provide the opportunity for higher returns, especially for those with a longer time horizon, American Electric Power employees should weigh the high initial investment requirements and limited liquidity before considering it as part of their retirement strategy.' – Patrick Ray, a representative of The Retirement Group, a division of Wealth Enhancement Group.

In this article, we will discuss:

1. Private equity basics and just why it differs from public market equities.

2. The different forms of private equity, such as venture capital, buyout, and distressed debt.

3. The advantages and disadvantages of private equity investments, including accessibility, liquidity, and tax implications.

What is Private Equity?

We have been able to find out that many of our American Electric Power customers have shown interest in private equity. Like stock, private equity is equity, but it is not like securities because private equity investments are not bought or sold on a public market or exchange, although some firms that specialize in private equity are publicly traded. Not all private equity firms are required to register with the SEC. Moreover, firms that manage private equity investments may be more hands-on in the management of individual businesses than the ordinary shareholder. Private equity usually takes a long time before investments start to produce significant cash flow, if at all. Private equity usually requires a relatively large initial investment and is only available to accredited investors, including pension funds, institutional investors, and high net worth individuals.

The Many Faces of Private Equity

At this point, many of the American Electric Power employees may be interested in learning more about the different forms of private equity. Here are some examples:

Angel investors are individual investors who provide capital to startup companies and who may have a personal interest in the business, besides providing business expertise, industry experience, and contacts.

Venture capital funds invest in companies that are not yet mature and may not yet be cash flow positive or profitable. The venture capital fund gets a stake in the company as a charge.

Mezzanine financing is a form of financing where private equity investors provide debt to an established business with the condition of getting equity if the debt is not paid as agreed. Normally subordinated to other debt, it is usually used to raise capital for expansion or mergers and acquisitions. Therefore, from the point of view of an investor, mezzanine financing can be attractive because the loan's interest rate can be fairly high.

Firms specialized in distressed debt focus on taking over the debt of companies in distress, including those that are or are about to be bankrupt. They usually act as private equity firms, relieving the company of its debt in exchange for equity as they often do in their role as debt holders when the company is facing insolvency in order to restructure or liquidate the company and recover their investment.

Buyouts are when private investors, usually via a private equity fund, buy out a significant portion of or all of a public company and delist it. These investors think that the company is either cheap or that they can enhance its earnings and sell it at a higher price in the future, in some cases by merging it with other companies. In some cases, the private investors are company executives, and the process is called a leveraged buyout (LBO). It is not issued by investors only, but also by bonds issued by the private equity group to finance the acquisition of the outstanding stock. The 1988 acquisition of RJR Nabisco was the subject of the book  Barbarians at the Gate , as well as the film  Wall Street . Nonetheless, today's buyouts are generally less hostile than those of the late 1980s; for instance, many of them involve the spin-off of a division of a large company or the sale of a family business.

Private Investment in Public Equity is the short form of Private Investment in Public Equity. Private investors (such as hedge funds or private equity firms) buy unregistered securities issued by corporations through PIPEs. In most cases, the company later lists these shares with the SEC so that other private investors can buy and sell the shares to the public. PIPEs are more popular with companies that need to raise capital faster than they can with a conventional equity offering. At times, the PIPE is a form of acquisition.

Private equity investment advisors were generally not required to register with the SEC before the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Nevertheless, as of mid-2011, the Dodd-Frank Act required private fund advisors with assets under management of $150 million or more to register with the SEC. Individual states are responsible for regulating funds with assets of less than $150 million but are allowed to exempt private funds from registration. Private equity and hedge funds have been growing and have begun to overlap in some areas. For instance, some companies now offer hedge fund and private equity investment opportunities.

Private Equity and Limited Partnerships

We would like to make sure that our American Electric Power clients understand what a Limited Partnership is. Most private equity investments are made through a limited partnership (LP). A limited partnership is a business structure that has one or more general partners and one or more limited partners. The general partner runs the business and has unlimited liability for the company's debts and liabilities. The limited partners are passive investors; they put in their money, have limited liability, and do not manage the business. Federal income tax is not levied on the partnership level, but the financial and tax events are passed on to the individual or institutional investors directly. When you invest in a private equity LP, you only report your share of the business's income, gains, losses, and deductions on your individual tax return (see below).

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Before the Tax Reform Act of 1986, LPs were a very effective tax shelter as an investment vehicle. As a result of the Act, partnership losses can only be set off against passive income from another investment (see below). Although some LPs now focus on income, appreciation, and safety, the ability to shelter cash flow and value as a tax shelter has been greatly reduced by the Act. A limited partnership can be either private or public, as the name suggests. A master limited partnership is a publicly traded limited partnership.

How Can I Invest In a Private Equity Firm?

It is also important that American Electric Power employees understand how to invest in a private equity firm. Individual investors may have limited access to private equity investment opportunities because of the high capital requirements that are typically associated with them. A million-dollar minimum investment is not uncommon for the most sought-after companies. Furthermore, those who are qualified to engage in private equity may not be able to invest with a particular firm, as the most sought-after firms are able to select their investors. Diverse requirements exist for private equity investments. A simple contract may be enough for the most casual of agreements, such as seed money from an individual investor to a company. On the other end of the spectrum, the majority of investors in private equity firms are institutions.

In order to invest, an individual has to meet one of the following conditions: (1) has a net worth of $1 million (not including the primary residence); or (2) has earned at least $200,000 in each of the two immediately preceding years (or, if the taxpayer is married, $300,000 with his or her spouse) and reasonably believes that he or she will continue to earn at least that amount in the current year. (A company may have up to 35 unaccredited investors as limited partners.) Institutional investors must have sufficient expertise, for instance, a bank, an insurance company, or an investment company, or at least $5 million in available assets. Hedge fund managers, however, that fund the investments of other investors, such as through funds of funds, may have much lower minimums than a typical mutual fund.

Why Do Investors Put Money Into Private Equity?

It offers greater flexibility as an investment tool that diversifies the portfolio. Private equity firms argue that because they have more control over their strategic decisions, they are able to produce returns that are both higher and less sensitive to the market. Private equity as an alternative asset class is another way to diversify a portfolio. The returns are usually not tied to the stock market as much as they are to the performance of a particular company or the management of a private equity firm.

It Can Offer a Chance to Be Part of a Business Success Story. Investing in early-stage companies and venture capital may make you a part-owner of the company you are investing in. Many investors get psychological satisfaction from helping to develop a new company.

It Can Be Highly Profitable. An effective private equity investment can be very profitable despite the high risk. This is because a private equity investment can be very profitable even if the company goes through a merger, an acquisition, or highly profitable operations. And many of the most experienced managers are attracted to the field because of the opportunities to participate in mergers, acquisitions, and highly profitable deals. A successful investment in a company at an early stage can produce very high returns.

Some People Consider Limited Access to Have a Positive Snob Value. Private equity investing is said to have some level of prestige. Due to the high investment minimums and very limited access to the best private equity firms, some investors are attracted to private equity like they would to a private club.

What Are The Disadvantages of Private Equity Investments?

You May Not Meet the Eligibility Requirement for Making a Private Equity Investment. Angel investors can be anyone who is willing to give money to an entrepreneur. However, private equity firms can only allow a certain number of investors, and those investors have to meet the requirements of the SEC.

Freedom from Regulation Is a Double-Edged Sword. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 requires private equity firms with assets under management of more than $150 million to register with the SEC, while other firms are exempt. Furthermore, the investment freedom that private equity enthusiasts see as an advantage can mean much higher risk. Due to the fact that there are no restrictions on how private equity firms are supposed to invest, a single large, disastrous investment can bring down the whole firm. It can be quite difficult to work out how your returns are being achieved. Private equity firms have historically been very cautious about revealing their strategies, which they see as being proprietary information. As a limited partner, you rely on the general partner's reputation for competence and honesty.

The investment can be quite large. Even if you are eligible to invest in private equity, the size of the investment may have a significant impact on the overall portfolio and the level of risk you bear as an individual.

Limited liquidity can be a problem. This is because private equity is not publicly traded, there is no market for your shares when you want to sell.

Private Equity Is a Long-Term Investment. For our American Electric Power clients who are considering private equity, we would like to remind you that your money is likely to be tied up for a fairly long period of time. If you are to get any return at all, it may not be for several years. In fact, private equity firms may require you to agree to a contract detailing how long you agree to keep your money invested.

You May or May Not Have Any Say in How Your Money Is Spent. As an angel investor or venture capitalist, you may have a stake in the business that your money is in. As a limited partner of a large private equity firm, these American Electric Power employees should be aware that they will have a very limited role to play.

Investing costs may be steep. The general partner of a limited partnership will usually charge a management fee of 1.5 to 2.5 percent on your investments. In addition, the general partner will receive between 20 and 30 percent of the profits of the partnership.

The Risks and Uncertainty Are as High as the Potential Rewards. Early-stage, venture capital, and distressed debt investments are high-risk by definition. You are essentially investing in a company that has not yet established a track record, the products that it offers may not have been tested in the market, and the management and business plan of the company may or may not be sound. There are investors who have lost their entire stake in a small company that went bankrupt or never even got off the ground for every Microsoft investor success story.

Tax Aspects of Limited Partnerships

As mentioned above, we would like to remind our American Electric Power clients that partnership losses can only be set off against other passive income. Limited partners (passive investors) can only set off passive income against other passive income and not against earned income or investment income. However, unused losses can be carried forward to offset gain from the sale of the passive investment or used to offset gain from other passive activities. A limited partner's interest is determined by the amount of money he or she has contributed to the partnership, as well as the adjusted basis of any property that he or she has contributed.

This basis is increased by any additional contributions, his or her distributive share of income, and (if applicable) the excess of depreciation deductions over the basis of the depreciable property. Basis is decreased (but not below zero) by current distributions and the partner's distributive share of losses and certain non-deductible expenses. If applicable, the basis is also reduced by the amount of the depletion deduction for oil and gas wells. For purposes of the alternative minimum tax (AMT), net losses are treated as tax preferences. Also, most MLPs are currently taxed as corporations.

Additional Fact:

Private equity investments have been found to be useful in addressing the retirement income problem of individuals in their 60s. According to a research study done by The Wharton School of the University of Pennsylvania, private equity returns have outperformed traditional asset classes like stocks and bonds in the long run, especially for investors with a longer investment horizon. The study found that private equity investments can provide higher returns than traditional assets, which can help individuals bridge the gap between their retirement savings and the cash they need during their retirement years. (Reference: 'The Case for Private Equity in Retirement Plans,' The Wharton School, University of Pennsylvania, 2022).

Added Analogy:

Private equity can be compared to being part of an exclusive investment club with access to high-potential ventures. Let’s assume you are a golfing enthusiast and you want to become a better golfer. Rather than playing on public courses, you decide to join a high-end country club that is famous for its facilities and instructors. As a member, you become part of an exclusive network of golf enthusiasts who can invest in state-of-the-art equipment, individual coaching, and advanced training programs. It is not only a sign of prestige but also a chance to grow and possibly get great results. In the same way, private equity provides experienced investors, including American Electric Power employees who are about to retire, access to potentially high-returning businesses that can pay off over the long term. It offers the potential for growth, diversification, and the ability to be part of great success stories. Just as the country club enhances your golfing experience, private equity can help take your investment portfolio to the next level and provide opportunities that are tailored to your financial goals.

Sources: 

  American Investment Council.   Private Equity Delivers the Strongest Returns for Retirees Across America.  American Investment Council, 2024,  https://www.investmentcouncil.org/wp-content/uploads/2024/07/2024-AIC-Pensions-Report_final.pdf?utm_source=chatgpt.com .

Medium.   7 Strategies for Incorporating Private Equity and Venture Capital into Your Retirement Portfolio.  Medium, 2024,  https://medium.com/calendar/7-strategies-for-incorporating-private-equity-and-venture-capital-into-your-retirement-portfolio-860d8dca2d15?utm_source=chatgpt.com .

Urban Institute.   How Might Investing in Private Equity Funds Affect Retirement Savings Accounts?  Urban Institute, 2021,  https://www.urban.org/sites/default/files/publication/104729/how-might-investing-in-private-equity-funds-affect-retirement-savings-accounts.pdf?utm_source=chatgpt.com .

Morningstar.   Is Your Retirement Plan Missing Out on Private Equity?  Morningstar, 2024,  https://www.morningstar.com/retirement/are-retirement-investors-missing-out-private-equity?utm_source=chatgpt.com .

Landsberg Bennett.   The Essential Guide to Alternative Investments for Retirees.  Landsberg Bennett, 2024,  https://landsbergbennett.com/blogs/insights/the-essential-guide-to-alternative-investments-for-retirees?utm_source=chatgpt.com