Private vs. Public Markets - Why It Matters
- Private investments include equity and debt, similar to their public counterparts.
- There are diversification benefits, but there are unique risks and challenges that investors should be aware of prior to investing.
- Recent developments in the FTX debacle highlight the importance of due diligence that is required in private investing due to lack of transparency and in many cases, lack of liquidity.
A Primer on Private vs. Public Investments
Investing in private companies has historically been reserved for large pensions, endowments, foundations and other large institutional investors. Over the past several years, asset managers and funds have increasingly brought their offerings to the mass affluent, introducing a whole new swath of investors to these types of securities, without the large initial commitments that they once demanded.
In this edition of Connecting The Dots, our goal is to give a quick overview of the private investing landscape and lay out difference between investing private vs. public securities.
Types of Private Securities
Just like we have stocks and bonds that we can invest in through public markets, private companies also have equity and debt that you can invest in. Both of these types of securities carry their own inherent characteristics, which can add a layer of diversification to their public market equivalents. The largest differentiator of public vs. private investments is that public investments are generally extremely liquid, meaning that those securities can be sold in fairly short order with little frictional cost. Private investments are, in most cases, extremely illiquid, meaning that you cannot sell your shares in a private held company quickly and there can be a wide disparity in how those investments are valued, or what a willing buyer or seller accept. However, most investors require higher returns from private investments in exchange for the lack of liquidity that come along with private investments.
Within private equity and debt, there are different types that are commonly available to investors. Here is a brief summary of the different types:
Angel Investing / Venture Capital - Angel Investing is the earliest stage of Venture Capital investing. Angel Investing is when the business idea/plan is in it's infancy stages. Usually this is when family and friends are offering whatever money they can to help get the idea off the ground. Think of Steve Jobs and Steve Wozniak starting Apple in Steve Jobs' parents garage. Venture Capital (VC) investors then come in shortly after there is some proof of concept and the founders can convince outside parties that their business model will work. At this stage of the investing lifecycle, failure of the company is still highly likely and if a VC fund invests in 10 companies, they may expect seven to nine to go broke and those one to three investments will be homeruns. Investors generally expect to make many multiples on their initial investment, i.e., 5x to 10x or more.
Buyout Equity - This generally involves a private equity firm buying a company that is publicly traded, usually by borrowing the money or through fund raising. The profile of company that is taken over is usually a mature company that the private equity company feels they can add value either through cost cutting efficiencies or implementing a new business strategy that the existing leadership or board may not agree with. This strategy usually has the lowest expected return profile, generally in the low to mid teens compounded annually, but also carries the least amount of risk because the company being acquired is already an operating company. With public markets, especially in the tech space having taken such a beating this year, there have been several acquisitions of technology companies by private equity funds, most recently Thoma Bravo buying publicly traded company Coupa Software (COUP).
Growth Equity - Growth equity investors will usually step in once there is a proven business model, but the company may be pre revenue or they may be generating sales but still operating at a loss due to product development or building out their manufacturing and/or distribution infrastructure. These investors may participate in 2nd or 3rd funding rounds. Investors in these securities usually require high teens to 20%+ returns compounded annually on their investments.
Private Real Estate - Owning shares in a fund that owns institutional grade real estate can add a different dynamic to a diversified portfolio. Private real estate funds usually offer a higher level of income to their investors, as they pass along the income from rents that they collect to their investors. Investors in these funds also enjoy the potential for price appreciation on the underlying real estate owned in the funds. Investors in real estate in most cases enjoy tax benefits that other types of private equity do not enjoy, making the investment very tax efficient.
Private funds also extend debt securities to private companies, which is also known as direct lending. Most of the companies that are seeking funds via direct lending are small to medium sized companies, usually in the range of $25 million to $250 million in EBITDA (earnings before interest, taxes, depreciation and amortization).
For the most part, lenders are issuing debt that is senior secured, meaning that in the event of a bankruptcy, the debt issuers are repaid first. Given that the companies are seen as more risky than their larger, publicly traded counterparts, the debt usually carries a higher level of interest than publicly traded bonds.
There are other debt strategies, aside from direct lending, which include subordinated debt, usually called "Mezzanine" which is in most cases used to fund a gap or short term project versus the longer term debt mentioned above. There are also managers out there who look for distressed debt, which can be when a company violates a covenant and the debt goes into "non-performing" or distressed status. Management teams who employ strategies like this will buy the debt from the original company that underwrote the debt, usually at a discount, and will work to rehabilitate the company and get the debt back to "performing" status where they are paying the interest owed to the debt holder.
Pros and Cons
Let's start with the pros of private securities. Clearly, the expected returns on both the equity and the debt issued to private companies carries a much higher return proposition than publicly traded companies, unless you have the mother of all short squeezes like we saw in GameStop in 2020! Another desirable feature is that there is a level of lower correlation between public and private markets, mainly because the private securities are not valued daily or instantly like stocks or bonds on a public exchange. This is arguable in that some would say the lower correlation, or non-correlation, doesn't really exist because when the proverbial "stuff" hits the fan, these securities will eventually be marked down like their public market peers, raising correlations closer to 1.
There are, however, significant cons, which have been on full display with the fantastic implosion of FTX and all of the counterparts. First, lack of transparency into the financials and running of the company. Private securities do not have to publicly disclose their financial documents and are not subject to the same accounting standards as publicly traded companies. It is a best practice to use a reputable accounting company who has experience with preparing company financials and does not present the risk of preparing fraudulent documents.
Second is lack of liquidity. As we touched on at the beginning, private securities are not readily available to trade amongst counterparties. There are secondary exchanges which help to facilitate buyers and sellers, however, this is more akin to selling real estate than selling a publicly traded security. In many cases, when an investor is trying to sell a private security, it usually is done so at a discount to what the value of the securities are. There are cases where it can be at a premium, which is when a private company has so much hype or potential growth opportunities that investors who were not able to get access to funding rounds will buy on the secondary market before the shares go public or are bought out by someone else. This is usually the exception to the rule and in more cases than not, private securities are traded at a discount.
Funds may allow for limited liquidity, but may restrict redemptions to a certain amount of percentage of the fund. In recent news, Blackstone recently limited redemptions for their investors in their real estate fund and credit fund. These provisions are put in place to protect existing investors from being adversely impacted by the fund having to make sub-optimal investment decisions to accommodate investors who want out. These provisions are clearly stated in subscription documents and investors should be fully aware of all liquidity provisions before investing in private funds.
Connecting The Dots...
The evolution of the private market over the past several years has allowed many investors the opportunity to gain access to securities that they otherwise would not have been able to. In certain circumstances, this can be a good thing. However, when investing in private securities, there has to be an extra layer of due diligence and investigation in to what the company is up to and how they operate. Too many times over the past decade, we have seen even the most experienced, professional investors seemingly get hoodwinked. Elizabeth Holmes at Theranos was the hottest company back in the early 2010's. Adam Neumann at WeWork was another fallen star that had nosebleed private valuations, only to go bankrupt. Sam Bankman-Fried and FTX was the most recent example of an "Icarus" parable. For those who aren't fresh on their Greek mythology, Icarus flew too close to the sun and the wax on his wings melted. He fell from the sky into the ocean and drowned.
Certainly, there is a place for private investments within a diversified portfolio, however, our advice is either do your own rigorous research and know what you own, or engage with a professional who will do so for you on your behalf!
As always, we are here to answer any questions or have a further conversation about how private investments may work for you.
Gordon Asset Management, LLC Investment Policy Committee