Lifting the lid on private markets

Worth more than $5 trillion in 2020, up 8 percent year-on-year, private equity, one form of private investment, outperformed all other private asset classes and most public market equivalents, according to McKinsey.¹ 

Every investor is after this kind of alpha return, but many stick to the public markets, lacking the experience and knowledge required to navigate the private market opportunity. Indeed, private markets can be hard to access, price and accurately assess their potential without the right experience or partner. But a diverse portfolio, which includes private market investing, is imperative to minimize risk and maximize returns.

Private investment consists of various forms of investments in unlisted companies and their debt. It can be in the form of a direct company investment, or via private equity or venture capital funds accessed through banks or other intermediaries. With companies generally staying private for longer these days, it can offer attractive investment opportunities in otherwise unavailable companies, providing an effective way to diversify a portfolio.² Indeed, family offices typically allocate 29 percent of their assets to private markets. But anyone considering taking this alternative route should be aware of the differences between private and public markets and the possible consequences.

Private markets are different

Perhaps the most obvious differences are liquidity, transparency, regulation and risk. That said, it’s important to stress that differences don’t have to be disadvantages. For example, the liquidity offered by a publicly listed company certainly makes it easier to enter and exit quickly. But that liquidity can also bring volatility and it can be hard to ignore “noise” – distracting reports that have a short-term effect on the share price. Public markets are also subject to more regulation surrounding reporting and financial transparency, all aimed at making them safer and fairer for investors. But it’s worth remembering that public companies do fail. Which brings us to risk.

All investments carry risk, but some more than others. Anyone considering investing privately should keep in mind a number of factors. For example, many opportunities will be in early-stage companies, which are inherently risky investments. It’s worth assessing whether management is competent to oversee this successfully. Whether there is a key-man risk, where (usually) the founder is the lynch-pin upon which success is based. The market itself might be so new that regulators have yet to become involved – think cryptocurrency and non-fungible tokens. Consumers are also notoriously difficult to read, making it hard to assess demand. And so on. But again, there is an upside. Increased risk should mean higher potential rewards.

Choose carefully

When choosing an investment, the theory goes that it should be according to sector expertise. In practice this may not always be the case.

More generally, however, environmental, governance and social (ESG) investing, where purpose is the driving force, is an increasingly common factor. But whatever the motive, just as with any investment, account should be taken of the risk-reward profile, size of investment, timescale, region, regulatory outlook, expected dilution from follow-on rounds, and most importantly one’s own experience/knowledge of the sector.

Access restricted opportunities

Opportunities exist across the board from space to pharma to food. They also come in all shapes, sizes and ages. While there are plenty of start-up or early-stage companies, it’s not uncommon for later-stage companies to raise large funds before a potential IPO or sale of the company.

Access to these opportunities can be direct or via third-party introductions through private equity and venture capital funds or professional managers. Other players include banks and networks.

While there are ample opportunities, it’s worth noting that the window can close very fast – and may not even be open to all. Some private companies will raise capital over a matter of weeks or a couple of months and only open the opportunity to their existing network of family offices, sovereign wealth funds, private equity funds, etc. 

Advisors can reduce risk

The size of investment varies enormously, although $500k to $1 million is generally the starting point. But whatever the size, it’s tough to invest successfully without help. Advisors such as banks, funds and networks may bring broad and deep experience of different sectors, companies, regions, needs by maturity and more. They can also advise on valuations – a notoriously difficult exercise – undertake due diligence and negotiate any add-ons, such as seats on the board, a role as an advisor or escalating payouts. For direct investors, the full burden falls to them and is therefore only advisable when they are sophisticated and experienced.

Whether investing alone or with advisors, returns are not guaranteed. You may even lose all or some of your invested capital. Generally, private equity and venture capital firms work on the principle that out of 10 investments, three make money, a few wash their faces and the rest fail. To help reduce risk, some private investors will invest via several funds, each a leading specialist in a sector – perhaps pharma, fintech, food tech or infrastructure. But well-chosen private investments should perform well and can bring big financial rewards. For example, last year one company introduced to Credit Suisse private clients in a pre-IPO round went public at double the price a year later. 

Reap non-financial rewards

For many private investors, while the financial return is a priority, it is also common that they become emotionally involved with their plays and find they benefit from less tangible rewards. This may be down to the fact that they do more research – private investments are rarely followed by brokers and analysts. Or because the motivation was ESG and they feel they are making a difference. Or the play is in a field about which they have always wanted to know more and so it becomes a quasi-hobby. It may even be pride that they got into “the next big thing” early or that they are able to advise the company, drawing on their own experience. 

The world of private markets is vast and full of potential, and there is much to be gained by exploring the sector to meet investment return targets. As with all investment decisions, a well-devised strategy leads to the best outcomes.