Private market investments (often referred to as “alternative investments” or “alts”), such as real estate, infrastructure, private credit, and private equity, offer unique opportunities not available in public markets. Incorporating these assets into your portfolio can unlock higher returns, reduce market volatility, enhance estate planning, improve tax efficiency, and provide greater diversification. As private markets continue to gain traction and become widely accessible, more investors are seeking ways to effectively integrate these assets into their portfolios.
In this post, we will explore the key benefits of private investments and how they can help you build a more robust and resilient financial strategy.
Achieving Higher Returns with Reduced Volatility
Integrating private investments can enhance portfolio diversification and offer potential for improved risk-adjusted returns beyond the limitations of a traditional stock-and-bond portfolio. The traditional 60/40 portfolio has struggled amid rising inflation, higher interest rates, and increased stock-bond correlations, impacting both asset classes. In 2022, these challenges contributed to a 17% loss, marking the 60/40’s worst annual performance since the 1930s.1 These factors, along with emerging risks such as rising debt levels, shifts in globalization, and technological disruptions, could pose additional challenges to the 60/40 portfolio model from an asset allocation and risk perspective.
Private investments often present the potential for higher returns compared to traditional public market assets. Several factors contribute to this, including less market competition, long-term value creation, and the illiquidity premium. In private markets, investments are typically not subject to the same level of market scrutiny, allowing for significant upsides in undervalued or growing companies that have not gone public. Many private equity investments focus on driving growth through operational improvements, mergers, acquisitions, or restructurings, which can lead to higher returns over time. Unlike public companies that may prioritize short-term profits, private companies often emphasize long-term value creation. Additionally, investors in private markets are (and must be) willing to accept liquidity risks, which can translate into higher returns for those able to lock up capital for extended periods.
Private investments also help reduce a portfolio’s exposure to market volatility.2 They often have low correlations with public markets, making them less susceptible to daily market fluctuations driven by macroeconomic events and market sentiment. Private equity and private credit tend to rely more on company or asset fundamentals. Private credit, for instance, can offer steady and predictable cash flow, which is especially attractive during periods of higher interest rates and bond market volatility.
Diversification and Risk Management
Incorporating private investments into a portfolio enhances diversification and strengthens risk management. Unlike traditional asset classes such as stocks and bonds, private investments tend to operate independently of market fluctuations. This independence helps reduce overall portfolio volatility, particularly during periods of market uncertainty or economic downturns. As a result, when public markets are experiencing downturns or heightened volatility, these private assets may continue to perform well, thus stabilizing portfolio returns. Moreover, private investments often have longer investment horizons, which can further buffer portfolios against short-term market swings. Additionally, Private investments offer broader exposure to industries and sectors that may not be available through public markets. This includes niche opportunities in areas such as private real estate developments, startups, or international markets with fewer publicly traded companies. By gaining access to these alternative sectors, clients can benefit from a wider range of growth opportunities and reduce concentration risk in their portfolios.
Tax Efficiency and Estate Planning Benefits of Private Investments
Private investments provide multiple opportunities for tax optimization. Through mechanisms like tax-deferred growth, long-term capital gains treatment, depreciation, and strategic estate planning, private assets offer significant advantages in managing and reducing taxes. Whether through direct investments in real estate or small businesses, or through complex tax-efficient structures, private investments are a powerful tool for wealth preservation and growth in a tax-efficient manner.
One of the primary advantages of private investments is tax-deferred growth. Taxes on income and capital gains are not due until the assets are sold or distributed. Therefore, the deferral of taxes enables the investment to grow without the drag of annual tax payments, allowing for compounding returns over time. This long-term growth potential is especially beneficial for investors looking to build wealth over extended periods.
In addition to tax deferral, many private investments qualify for long-term capital gains tax treatment. When an investment is held for over a year, the gains from the sale are taxed at a lower rate compared to ordinary income. This preferential treatment can result in significant tax savings, especially for investors in high tax brackets. The lower capital gains tax rates create a compelling reason to hold private investments for the long term, which in turn benefits the investor by reducing their overall tax burden.
Investments in Qualified Small Business Stock (QSBS)3 present another tax-efficient option for investors. When an investor holds shares in a qualifying small business for at least five years, they can potentially exclude up to 100% of the capital gains from the sale of those shares. This is a powerful tax incentive that can be extremely beneficial for investors in startups or other small businesses. The QSBS exemption encourages investment in early-stage businesses while providing substantial tax savings upon exit. Additionally, Opportunity Zone investments4 offer significant tax incentives, making them an attractive option for investors seeking both tax relief and social impact. Additionally, Opportunity Zone investments provide tax incentives like deferral of capital gains taxes and the potential exclusion of gains if held for 10 years.
For estate planning, private investments can play a critical role. Family Limited Partnerships (FLPs) or trusts enable individuals to transfer assets to heirs at a reduced valuation, which can lower estate taxes. Additionally, irrevocable trusts can remove assets from an individual’s taxable estate, reducing estate tax liabilities upon death, ensuring wealth is passed on efficiently.
A caveat. It is important to recognize and understand that private investments come with their own set of risks, including liquidity risks and valuation uncertainties. As such, these investments should be integrated into your portfolio with careful consideration of your risk tolerance, time horizon, and financial objectives.
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