Investments in private companies. Making the most of investment opportunities.
Those investing in private companies can find hidden gems with high returns. But these investments also present risks. What investors should bear in mind when investing in private companies.
Strong performance for investments in private markets
Lately, private markets have offered attractive investment opportunities. With a value of more than USD 5 trillion in 2020, for example, the private equity asset class has outperformed all other private asset classes and most equivalents on the public market.1 Additionally, over the past ten years, unlisted companies have performed better overall in many markets than publicly traded companies.
However, the larger potential returns from private market investments should not make us forget the risks. For instance, much less information is available about unlisted companies, making a correct assessment of the investment more difficult. Furthermore, investments in private markets are illiquid. A timely exit in bad times – as we are seeing in 2022 – is accordingly difficult or, in the worst-case scenario, impossible.
Timing can be everything
In addition to the preferred asset class, investors must also decide during which life cycle of a company they wish to get on board. After all, the risk/reward ratio of onboarding just before the flotation is very different from that of an investment in the early growth phase of a company. Since it is still unclear after the early stage whether a company will stand the test of time, an early investment does tend to present a higher risk, but also offers the chance of higher returns in case of a successful sale or flotation.
The situation is different for investments in the last round of financing prior to a flotation. For such pre-IPO investments, the time horizon is generally shorter. In this phase, it is advisable to check precisely how much was invested in preferred stock during previous growth rounds. This is because, in the case of a flotation or sale of the company with a valuation lower than the last financing round, said stock would receive preferential treatment.
Another factor is the lock-up period. Generally, investors must commit to holding the shares invested pre-IPO for six months after the flotation. While this lock-up period offers stability for companies in the delicate phase after the IPO, it can be unpredictable for investors. This is because the lock-up prevents them from immediately benefiting from a positive price trend or selling the shares in case of an impending price drop.
The valuation of companies is complex
The valuations of companies offer some guidance for finding interesting companies in private markets. However, the question of whether a privately held company is attractively valued or too expensive is not always easy to answer. The small amount of information available regarding business performance makes an assessment more difficult.
In order not to miss a promising investment opportunity, investors must therefore use comparables: How is the company performing compared with the competition in the same sector? What prices were recently paid for shares from comparable companies?
Risk diversification through investments in funds
By selecting fund solutions, investors can minimize private market risks. This is because funds offer not only broad diversification of the portfolio, but are also part of a professional investment process, in which a team of specialists manages the invested assets. In this context, however, it should be noted that the time horizon and the capital tie-up tend to be longer than for direct investments in private companies.
In addition, it is also important to keep an eye on the broader market environment. As we've recently seen, falling stock exchanges can delay a flotation or a sale or cause the achievable price upon IPO to drop significantly. This can lead to painful losses or a longer-than-expected capital commitment for investors.
1 "McKinsey’s Private Markets Annual Review" (McKinsey & Company), April 2021