Here’s why every investor should invest in private companies

The shrinkage of public markets has been a well-documented phenomenon for many years now. Between their peak in 1996 and 2018, the number of publicly-listed companies in the US fell from 8,090 to 4,397, according to World Bank figures. While the trend reached its nadir in 2012, and the past couple of years have seen IPOs (initial public offerings) make a strong comeback, it seems clear that “going public” is no longer automatically the first port of call, or even the end goal, for ambitious entrepreneurs.

Even those companies that do eventually go public, often come to market at a later stage than might once have been the case. You need only look at the recent history of the tech sector to see this in action – many of the biggest names had already achieved “unicorn” status (a valuation of more than $1bn) before they went public, with their early backers enjoying a substantial proportion of the gains. Yahoo famously bid $1bn for Facebook (or “Meta” as it’s now known) as early as 2006. On the day it went public in 2012, Facebook attained a market capitalisation of more than $100bn.

There are several factors behind this trend, some more obvious than others. One is the fact that many founders would rather grow their businesses away from the spotlight, the regulatory burdens, and the sheer short-term pressure of public markets. Another is that capital has steadily become more readily available from alternative sources. This has been driven in part by the lower interest rate environment, but that’s by no means the only factor. Governments have become increasingly keen to encourage investment into early stage businesses, and an entire ecosystem of investors actively looking to step in and invest at different stages of a firm’s development has blossomed.

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Finally, today’s businesses tend to be less capital intensive than those of the pre-internet era – they simply don’t need the level of capital that once made a public listing essential for those wishing to expand.

Given that these factors are unlikely to go away – even assuming future boom and bust cycles – it makes sense for private investors to look beyond public markets and add exposure to private companies to their portfolios. There is a diversification argument for doing so. Private companies tend to be at earlier stages of their development, or alternatively, coming out of extensive “turnaround” situations – so these aren’t necessarily the sorts of companies or situations you would typically find in public markets. Moreover, an investment into private markets can be viewed as a way to hedge an investor’s existing exposure to major stock market indices – the companies that are set to disrupt or even replace these established firms tomorrow, are today more likely to be found growing and thriving under private ownership rather than on the stock market.

Finally, in a world where passive investing is increasingly the dominant force in public markets, private markets are one area where truly active investing – with investment managers not just picking companies but actively working alongside them to improve their performance – can make a huge difference to returns.

But how can private investors get access to what has historically been an asset class restricted to larger investors? The good news is that there are many popular funds, including the likes of Scottish Mortgage, which already have some exposure to private companies in their portfolios. This just goes to show that forward-thinking managers already recognise how critical private markets are becoming to overall returns.

However, another – perhaps under-appreciated – option for building out your asset allocation to private companies is to consider a private equity fund of funds. Such funds offer a number of potential advantages. As a whole, funds in this sector typically still trade at historically high discounts to net asset value (in other words, you can purchase shares in the funds for less than the stated value of the underlying portfolio). Better yet, they also give a wide spread of exposure to companies across different stages of maturity – from very early-stage companies to those which may be about to join public markets.

In the next article, we’ll look at these different phases of development and why it makes sense to take this and other factors into account when considering how to diversify your exposure to private companies effectively.

Richard Hickman is director of investment and operations at HarbourVest Global Private Equity Limited. For more information visit www.hvpe.com

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