A truly diversified portfolio is one that spreads risk across a wide range of asset classes, sectors, geographical locations, and individual securities. The motivation behind diversifying is generally to generate more stable returns while reducing the impact of any single security or asset class. The qualified purchaser designation opens the door to additional investments in private markets, which creates the opportunity to help increase potentially higher returns over public markets while increasing portfolio diversification and reducing portfolio risk. A feat challenging to replicate in publicly traded markets.
What is a qualified purchaser?
The U.S. Securities and Exchange Commission defines qualified purchaser under the Investment Company Act of 1940. Achieving the designation is largely a self-certification process, where the individual or entity offers documentation showing a level of financial resources and sophistication required to invest in higher risk and reward opportunities in the private sector space.
Most qualified purchasers have substantial assets. For example, individuals with at least $5 million in investments or entities with $25 million in investments generally qualify for the status. The designation is important because it allows access to sophisticated investment vehicles that are otherwise restricted to protect less experienced investors from high-risk ventures.
For more information on this topic, read our articles:
- Private Investments: What is a Qualified Purchaser?
- The Benefits of Being a Qualified Purchaser
- Understanding the Distinction: Accredited Investor Versus Qualified Purchaser
Private equity funds
While most mutual funds and exchange-traded funds (ETFs) invest in baskets of stocks or bonds, private equity funds often invest directly in private companies. After pooling capital from qualified purchasers, private equity funds sometimes provide growth capital to companies that need additional funding or to restructure operations. Other times, private equity funds specialize in buyouts, which involves acquiring the company, restructuring it, and selling it for a profit.
Mostly out of reach for the average investor, some private equity funds can represent attractive long-term investments for qualified purchasers. Successful growth capital projects or buyouts have the potential for substantial gains when businesses are successfully restructured and sold. Also, because private equity funds often invest in multiple private companies, they can offer an element of diversification, which can reduce the risk of any one private company going sour. Quid pro quo: Why has the average private equity fund significantly outperformed the S&P 500 from 2000-2020 net of fees? Illiquidity. The above public market returns require the investor to give up access to capital for 10-12 years.
Hedge funds
With less regulation than mutual funds or ETFs, hedge funds can use advanced strategies to try to enhance returns or reduce risk. The term hedge is commonly used because these types of funds were originally created to reduce risk or “hedge” against potential losses. Over the years, however, hedge funds have expanded to include a wide array of different strategies:
- Short selling: Selling stock short involves borrowing shares (usually from a brokerage firm), selling them, and attempting to buy back later at a lower price. Some hedge funds specialize in short selling, which generally offers better returns when the stock market is moving lower.
- Long/short equity: Other hedge funds attempt to profit from buying stocks they expect to move higher and selling short those that are expected to underperform. Doing both can lessen overall portfolio volatility and success usually depends on accurately identifying overvalued and undervalued stocks.
- Global macro: Some hedge funds use currencies, interest rate futures, commodities, stocks, and bonds to invest based on macroeconomic trends. For example, a fund might use currencies to speculate on changes in interest rates across different countries.
- Event-driven: Mergers, acquisitions, bankruptcies, spin-offs, or restructurings can sometimes create opportunities for savvy hedge funds with enough capital to take advantage of these types of corporate events.
- Arbitrage: Sometimes an asset is trading at a price in one market and a different price in another market, which opens the door to arbitrage. Other types include convertible bond arbitrage, volatility arbitrage, statistical arbitrage, or relative value arbitrage. Each requires a high level of expertise that isn’t very common outside of the hedge fund world and requires that the investor have the qualified purchaser designation.
Venture capital
Like hedge funds, venture capital (VC) firms can specialize in a variety of different advanced strategies to generate profits for their qualified purchaser clients. Investing in early-stage startups is one example. Many times, these companies have high growth potential because of innovative products or services. However, with the higher growth potential comes higher failure rates. That’s why diversification and the qualified purchaser status are both important; they can make it easier to absorb the loss when a startup fails.
Other examples of VC projects include growth equity, late-stage investments, buyouts, secondary investments, restructurings, spin-offs, special purpose acquisition companies (SPACs), and environmental, social, and governance (ESG) initiatives.
Real estate
Buying a home or a lot of land doesn’t require the qualified purchaser designation. Publicly traded real estate investment trusts (REITs) can be bought or sold by anyone with a brokerage account. However, qualified purchasers can sometimes have access to exclusive real estate opportunities that aren’t available to average investors:
- Private real estate funds are diversified portfolios that can include commercial real estate, development projects, or other niche markets.
- Direct investments: Qualified purchasers can often co-invest in developments and other large-scale real estate projects directly.
Real estate is often overlooked as an essential part of a long-term portfolio. Nevertheless, as a tangible asset class, it can provide steady income and long-term capital appreciation. Directly or indirectly, qualified purchasers can invest in prime properties and developments that aren’t available to smaller investors.
Private placements
Sometimes companies want to sell securities to a select group of investors without a public offering. These are known as private placements and can include shares of the company, convertible debt, or other financial instruments. Using this approach, a company can raise capital without the regulatory requirements and expenses associated with a public offering.
For a qualified purchaser, a private placement can represent an opportunity to invest in a high-return potential investment that isn’t available to average investors. Because many placements are in early-stage companies, the return potential is high and so are the risks. In exchange for assuming the risk, a qualified purchaser can sometimes negotiate the terms, such as better pricing, and maintain a level of influence or control over the company’s strategic direction.
Specialized funds
While hedge funds use different investment strategies and real estate funds invest in properties or developments, other specialized funds invest in niche markets or strategies:
- Distressed debt funds target debt of companies that are currently in distress but expected to recover.
- Infrastructure funds invest in highways, airports, utilities, or other large-scale projects.
- ESG funds focus on investments that meet ethical or sustainability criteria.
Like real estate or hedge funds, specialized funds can offer the potential for higher returns and diversification benefits. Qualified purchasers can capitalize on those opportunities that align with their long-term investment objectives and tolerance for risk.
The universe of privately held assets is estimated to be more than five times larger than public markets.1 Some investments aren’t highly correlated with publicly traded stocks and bonds, which can aid in diversifying portfolios and generating more stable long-term returns. If you’re interested in learning more about the benefits of the qualified purchaser designation and how it can help in achieving a more diversified portfolio, please reach out to your wealth advisor at Mercer Advisors for ideas on getting started. Not a Mercer Advisors client? Let’s talk.
1 McKinsey Global Institute, “The Rise and Rise of the Global Balance Sheet,” 2021.
