It’s an idea that the richest and most powerful people in the business world almost never say out loud.
But takeover king Wilbur Ross knows it. So does Herb Allen, the most exclusive banker in the world. And you can bet your boots that billionaire Warren Buffett knows what I’m about to tell you. In fact, he’s often said these are the types of deals he wants to pursue.
Here’s Wall Street’s dirty little secret: The best investments in the world — those with the biggest returns and some of the highest yields — are not listed on any stock market.
They’re privately held.
According to an investing trade group, as of September 2012, the private market outperformed the S&P 500 by 2.5 percentage points, 5.5 percentage points and 5.7 percentage points for three-, five- and 10-year periods.
And it’s not limited to just recent performance. A study by professors at Duke and Ohio State covering a period from 1984 through 2010 found that private market investors earned 18% more than the S&P 500.
It’s proof that when it comes to investing, the rich really are different — they invest in better companies.
But exactly how do they do this?
Well, rather than buying shares on the stock exchange, savvy big hitters write a very large check to a very special kind of firm. To be eligible to invest like this, federal law stipulates that an investor needs to have at least $200,000 a year in annual income ($300,000 for a couple) and more than $1 million in net worth, excluding a primary residence.
That is a very high bar. Those rules block 94% of investors.
The official name for these highly exclusive firms is “private equity.”
A private equity firm has more than a pile of investor cash to offer. It also provides executive mentoring and business advice — often from some of the biggest names in corporate America.
I like private equity because a lot of private-equity firms do the exact same thing I try to do with my newsletter, Game-Changing Stocks.
They try to find the Next Big Thing, and they seek to invest in it before anyone else realizes that they’ve found the golden ticket. (For example, Amazon.com, Inc. (NASDAQ:AMZN) founder Jeff Bezos invested $250,000 in Google in 1998 — years before it even thought about going public.)
Here’s the good news: Private equity doesn’t have to be our competitor. It can be our partner. In fact, you and I can put private equity and its consultants to work for us the same way the billionaires do.
That’s because there is a way around the rules that bar ordinary investors like you and me from investing in private-equity deals.
And as these businesses grow, their private equity backers can get phenomenally rich.
For example, between 1973 and 2011, Yale University’s endowment fund generated average annual returns of 30.3% in private equity. That includes a monster return of 168.5% in the year 2000, when Yale made $2.1 billion on its private-equity investments.
Compare that 30.3% figure with the average gain of just 10.2% per year for the S&P over the same time period, and you start to see the type of impact that private equity could have on your portfolio.
