For most people, investing tends to revolve around familiar assets such as stocks and bonds. Beyond these traditional assets, however, lies a more esoteric realm of investment that has historically been the domain of institutional giants and ultra-high-net-worth individuals: private equity (PE).
As exclusive as private equity may have been, recent years have seen new technologies and investment strategies open private equity’s doors to a broader range of people. In this guide, we’ll shed some light on what private equity is, how to invest in it, and how platforms like Harness can help you manage the often complex tax considerations that come with it.
Table of Contents
- What is private equity?
- What are the benefits of investing in private equity?
- How do I invest in private equity?
- Understanding private equity taxation
- How Harness can help
- FAQs
What is private equity?
Private equity involves investing in companies that aren’t publicly traded on a stock exchange. Unlike public companies whose shares are bought and sold by anyone on the open market, private companies are owned by a smaller group of investors. These often include their founders, employees, and, most importantly, private equity firms.
Private equity firms, sometimes referred to as General Partners (GPs), are the architects of these investments. Renowned names in the private equity world, such as KKR, Apollo, and Blackstone, make it their business to identify promising private companies, typically those with strong growth potential or those that are undervalued. They then inject substantial amounts of capital into these businesses, acquiring a significant, and often controlling, stake in them.
A PE firm’s involvement goes beyond simply holding shares, however. PE firms are known for their active, hands-on approach to management. They work closely with the leadership teams of their portfolio companies to implement operational improvements, generate improved growth, and raise profitability for these companies. This active involvement is one of the hallmarks of private equity.
What are the benefits of investing in private equity?
Projections indicate that US private equity assets will reach over $1.1 trillion by 2033. This vast level of investment can be attributed to a broad range of advantages that set PE apart from conventional assets.
Higher return potential
According to FS Investment, private equity has, on average, demonstrated a historical track record of outperforming public markets over the long term. While that doesn’t serve as any kind of guarantee of investment success, the underlying mechanisms of PE—active value creation and access to earlier-stage growth—offer the potential for far superior returns to publicly traded companies. PE firms are often able to acquire companies at attractive valuations and implement effective strategic changes. The goal is to then sell these companies at a premium, generating gains for their investors.
It’s important to remember, however, that these higher returns tend to come with higher risks, with the illiquid nature of PE investments amplifying both gains and losses when compared to public market companies.
Portfolio diversification
With traditional stocks subject to the ebb and flow of market volatility, private equity offers an avenue for diversification. Private assets often exhibit different behavioral patterns compared to publicly traded stocks and bonds.
Their valuations are not subject to the daily whims of public market sentiment, providing a smoother, less market-correlated return profile. This can reduce overall portfolio risk and improve stability, particularly during periods of public market turbulence.
That said, investors should note that while PE may offer overall portfolio diversity, individual PE investments themselves are typically concentrated in a few companies. Investors can also face major “lock-up” periods, meaning their capital is inaccessible for several years, which can limit liquidity and flexibility.
Access to innovation and growth
Many of today’s most innovative and impactful companies choose to remain private for longer periods, often forgoing an early IPO (Initial Public Offering—or “going public,” if you prefer). As a result, they are able to focus on sustained growth away from the pressures of quarterly earnings reports.
Investing in private equity provides direct access to these leading-edge businesses, so investors can participate in their growth from an earlier stage and capture potential returns that public market investors may miss.
It depends on your appetite for risk, however. Gaining access to innovative private companies may offer a major upside, but it also means investing in less mature businesses with unproven long-term viability. The lack of public scrutiny and reporting requirements can also mean less transparency compared to publicly traded companies, potentially increasing informational risk for investors.
How do I invest in private equity?
For many years, investing in private equity was tied to the notion of being an “accredited investor,” with only individuals who met strict income or net worth criteria able to participate. This is not the case anymore. While some direct private investments remain restricted to accredited individuals, the PE arena has shifted dramatically. In fact, new structures and platforms are now offering much wider access.
Companies like Moonfare, for example, have made PE investment far easier for non-accredited investors. While PE investment commitments typically run into the millions (effectively barring all but the wealthiest investors), Moonfare pools capital from multiple individual investors, allowing them to collectively meet the high minimum investment thresholds for PE. This aggregation model allows everyday investors to gain exposure to high-quality private equity opportunities with more manageable investment amounts.
Beyond platforms like Moonfare, several other common access points have become increasingly prevalent for individual investors seeking PE opportunities:
Private equity-focused mutual funds and ETFs: These are publicly traded funds that, instead of investing directly in private companies, invest in publicly traded private equity firms or in a portfolio of private equity funds. They offer far more liquidity than direct PE investments, as their shares can be bought and sold on public exchanges. However, it’s important to note that the exposure can be less direct, as you aren’t investing directly in the underlying private companies.
Crowdfunding platforms: The rise of crowdfunding has opened up a direct avenue for individual investors to invest in private companies, often with much lower minimum investment requirements. These platforms allow startups and private businesses to raise capital directly from a large number of individual investors. Though they provide direct exposure and often exciting growth potential, these investments typically require more personal due diligence from the investor. These types of opportunities often involve earlier-stage companies that come with higher risks.
Business Development Companies (BDCs): BDCs are publicly traded companies specifically designed to invest in small and mid-sized private businesses, often providing debt financing or equity capital. They are required by law to distribute at least 90% of their taxable income to shareholders, making them attractive to income-focused investors. BDCs offer a liquid way to gain private market exposure, as their shares are traded on stock exchanges, providing an exit route that direct private investments often lack.
Each of these avenues offers different risk profiles, liquidity levels, and degrees of direct exposure to private assets. Irrespective of the PE avenue you choose to pursue, central to all successful private equity investments is efficient tax management.
Understanding private equity taxation
The appeal of high returns and diversification can make private equity an attractive proposition. That said, the tax implications of PE investment can be more complex than investments involving public market assets.
Capital gains vs. ordinary income
One of the major advantages of private equity profits is their preferential tax treatment as long-term capital gains. Most profits from PE investments are taxed at lower federal rates compared to ordinary income (provided the underlying asset has been held for over one year).
In 2025, these preferential federal rates are 0%, 15%, or 20%, depending on your overall taxable income. This can mean substantial tax savings, particularly for high-income earners.
It is also important to be aware of the TCJA Sunset. Many provisions of the Tax Cuts and Jobs Act are set to expire at the end of 2025. While this primarily affects marginal tax rates for ordinary income, it’s important to stay informed about potential legislative changes that could indirectly impact long-term capital gains brackets. Beyond this, high-income earners may face an additional 3.8% Net Investment Income Tax (NIIT) on certain investment income, including capital gains, if their modified adjusted gross income exceeds specific thresholds.
The Schedule K-1
If you invest in private equity funds, you’ll normally receive a Schedule K-1. This tax form details your share of the fund’s income, losses, deductions, and credits. Unlike the straightforward 1099 forms for public investments, K-1s can be complex, often containing various types of income and deductions that require careful interpretation.
A common challenge with K-1s is their late arrival, sometimes well into tax season, often requiring a tax extension to allow for proper preparation of your annual tax return.
Unrelated Business Taxable Income (UBTI)
For those investing in private equity through tax-exempt retirement accounts such as IRAs or 401(k)s, Unrelated Business Taxable Income (UBTI) is a key consideration. In simple terms, UBTI is income your tax-exempt retirement account earns from active business activities, not just passive investments like stocks or bonds.
If your share of UBTI from a private equity investment within your retirement account exceeds $1,000 in a given year, the retirement account itself may be subject to tax on that income. This can be a surprising and unwelcome development for investors accustomed to the tax-exempt status of their retirement vehicles. It’s essential to monitor UBTI levels when holding PE investments in such accounts.
State and Local Taxes (SALT)
Aside from federal taxes, income from private equity investments is also subject to varying state and local taxes (SALT). The specific rates and rules will depend entirely on your state of residence and the location of the private equity fund or its underlying businesses.
It’s also worth noting that the federal SALT deduction cap of $10,000 is set to expire at the end of 2025. This cap has limited the amount of state and local taxes that can be deducted on federal returns, and its potential expiration could severely impact your overall tax burden.
Qualified Small Business Stock (QSBS)
A powerful, but complex federal provision, QSBS allows eligible investors to exclude a major portion (potentially 100%) of the capital gains from the sale of qualified small business stock if held for over five years. That said, the rules governing QSBS are stringent regarding the company’s size, the industry involved, and the use of the proceeds. What’s more, these rules are currently under scrutiny, and potential changes for 2025 could affect the viability of this exclusion.
Given the inherent complexities of private equity taxation, individuals pursuing any kind of PE investment are strongly advised to seek personalized tax advice from a qualified professional who understands the ins and outs of private equity investments.
How Harness can help
At Harness, we specialize in connecting investors with highly experienced tax professionals who cater to specific circumstances and demands. If PE is an investment area you’re considering, we can connect you to a tax advisor with in-depth knowledge of PE structures who can advise on the most tax-efficient ways to invest.
With highly personalized tax strategies, an advisor from Harness can deliver year-round strategic tax advice to help you optimize both your PE investment returns alongside your entire portfolio. Make the most of your investments with Harness.
FAQs
Some common questions regarding private equity investment include:
What is private equity and how do private equity fund managers create value?
Private equity involves a PE firm investing in companies not traded publicly, acquiring ownership stakes. They actively enhance the underlying portfolio company’s value through operational improvements and strategic changes. This often involves optimizing costs, expanding market reach, and refining business models to strengthen cash flows. This ultimately increases the company’s valuation, leading to profitable exits and returns for investors.
How does private equity investing differ from traditional public market investments?
Private equity investing contrasts with public market movements by focusing on private companies, often with longer holding periods. Unlike mutual funds, PE offers less liquidity but aims for higher returns through active management, providing diversification beyond stocks and bonds.
Who are typical investors in private equity and how has access changed?
Historically, institutional investors like pension funds were primary participants in traditional private equity funds. However, new platforms are now democratizing access, allowing individual investors to participate in this exclusive private equity asset class alongside these large entities, often through multiple funds.
What types of private equity strategies exist beyond traditional buyouts?
Private equity strategies include venture capital investments (for early-stage companies), growth equity (for scaling businesses), private credit (providing debt to private companies), and even continuation funds, which allow private equity managers to hold onto successful assets longer, continuing to generate revenue.
How does private equity fund performance compare to other alternative investments like hedge funds?
Private equity fund performance has historically aimed for superior returns compared to public markets, driven by active value creation. Hedge funds also use alternative strategies, but private equity typically involves longer investment horizons and direct control over portfolio companies. These can lead to different risk-reward profiles for such investments.
How does private equity investing diversify a portfolio compared to traditional assets like bonds and other fixed income securities?
Private equity offers a different risk-return profile than bonds and other fixed income securities or public stocks. PE provides diversification because private assets are less correlated with public market fluctuations, potentially offering smoother returns and access to unique growth opportunities that are unavailable in traditional public markets.
What distinguishes private equity investors from those in public markets?
Private equity investors commit capital to illiquid assets, unlike public market participants. They typically seek higher returns over longer horizons and often tolerate less liquidity. Their focus is on the long-term growth and operational improvement of the underlying private companies, rather than daily stock price movements.
How do private equity funds fit within the broader category of alternative investment funds?
Private equity funds are a significant component of alternative investment funds, which encompass any investment outside of traditional stocks, bonds, and cash. This category also includes other private equity funds focusing on different strategies (like venture capital), as well as hedge funds, real estate, and private credit.
What are the key considerations when evaluating private equity performance?
Investors look at metrics like Internal Rate of Return (IRR) and investment multiples (like TVPI or DPI) to assess both the timing and magnitude of returns. It’s crucial to understand that PE performance often involves a “J-curve” effect, where early years show negative returns due to fees and investment staging.
Disclaimer:
Tax-related products and services provided through Harness Tax LLC. Harness Tax LLC is affiliated with Harness Wealth Advisers LLC, collectively referred to as “Harness Wealth”. Harness Wealth Advisers LLC is a paid promoter, internet registered investment adviser. Registration does not imply a certain level of skill or training. This article should not be considered tax or legal advice and is provided for informational purposes only. Please consult a tax and/or legal professional for advice specific to your individual circumstances. This article is a product of Harness Tax LLC.
Content was prepared by a third-party provider and not the adviser. Content should not be regarded as a complete analysis of the subjects discussed. Although we believe the content is reliable, it is not guaranteed as to accuracy and does not purport to be complete nor is it intended to be the primary basis for financial or tax decisions.
Past performance is not a guarantee or indicator of future results. All investments have the potential for profit or loss. This blog does not constitute advice or a recommendation or offer to sell or a solicitation to deal in any security or financial product. It is provided for information purposes only.
Certain information contained herein constitutes “forward-looking statements,” which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events, results or actual performance may differ materially from those reflected or contemplated in such forward-looking statements. Nothing contained herein may be relied upon as a guarantee, promise, assurance or a representation as to the future.
Private Equity Risks:
An investment in a Fund or Partnership entails a high degree of risk and is suitable only for sophisticated institutions and individuals for whom an investment in a Fund or Partnership does not represent a complete investment program. An investment in a Fund or Partnership requires the financial ability and willingness to accept the substantial risks and lack of liquidity inherent in such investment. Investors in a Fund or Partnership must be prepared to bear such risks for an indefinite period of time. Prospective Investors to a Fund or Partnerships should carefully review the applicable governing documents. Prospective Investors are also encouraged to consult their own legal, investment, tax, and other advisers, and the applicable offering documents, as to whether an investment in a Fund or Partnership is appropriate for them.
General Business and Management Risk. Investments in portfolio companies subject the Partnership to the general risks associated with the underlying businesses, including market conditions, changes in regulatory requirements, reliance on management at the company level, interest rate and currency fluctuations, general economic downturns, domestic and foreign political situations and other factors. With respect to management at the portfolio company level, many portfolio companies rely on the services of a limited number of key individuals, the loss of any one of whom could significantly adversely affect the portfolio company’s performance.
