Introduction to the World of Private Equity
When there are fewer bargains to be found in the stock market, investors will seek alternative ways to make money. So what else is out there besides stocks?
One viable option may lie in the enthralling world of private equity! 🙂
Investing in the stock market is like working in a knife factory; after a while things can get dull. But private companies can be much more exciting! For decades private equity has produced higher returns than the stock market! It does this by sacrificing liquidity. Unlike publicly traded stocks, private equity shares cannot be sold easily as there is no secondary market. Investors normally have to wait years for a return. 😨
Private companies can also use more leverage to increase their profits. To illustrate, the average debt-to-equity ratio of the S&P 500 is about 33%. But a leveraged buyout (LBO) deal will typically set a private company’s debt-to-equity ratio at 75%, or sometimes even as high as 90%. This intrigues to me on a philosophical level. As most of you already know, I also have a tendency to pile on the debt when acquiring new assets, hehe. 😁
In the past only institutional investors and privileged asset managers had access to private equity. But not anymore. 👍 U.S. officials recently passed Title III of the JOBS Act. This essentially creates a regulatory framework for which retail investors can finally access private equity deals. This was not possible even a year ago. Wow, what a time to be alive! 😉
In today’s post we’ll explore this fascinating asset class for retail investors, and how I might be taking my investments in this amazing new direction! 😀
So what is private equity? Generally speaking, it’s an asset class consisting of equity securities in companies that are not publicly traded on a stock exchange. Small but growing companies are very capital intensive and often have to spend a lot of money in the beginning to market itself and boost market share. But money doesn’t grow on sprees. 😆 So businesses rely on private capital as a way to fund their operations. Investors gain by having part ownership, or even executive influence sometimes, in these companies.
Some private equity deals are huge and often make it into the mainstream news. The CPPIB, which is the largest pension fund in Canada manages over $275 billion in net assets. It had the foresight to invest $300 million into a private company called Skype in 2009, which gave the pension fund a minority stake. Just 2 years later, Microsoft made the largest acquisition in its corporate history and purchased Skype for $8.5 billion. The initial $300 million investment turned into nearly a billion dollars for the sovereign wealth fund. Yay! Canadians who receive government pension benefits should celebrate.👴 LEGO is another prime example. It’s more profitable than Mattel and Hasbro combined. Businesses like these always attract the attention of private equity investors for obvious reasons.
But not all deals are measured in billions of dollars. One segment of private equity revolves around venture capital and smaller companies.
💵 What is Venture Capital? 💵
Venture capital describes early stage financing that investors provide to startup companies or small businesses that are believed to have strong growth potential. Venture capital is an essential source of money for startups because with limited operating histories they often don’t have access to traditional capital markets such as stocks or bonds to raise money. For investors the upside potentially can be very high, but so is the risk. Investing in a startup company is one of the riskiest decisions one can make, which is why due diligence and a thorough understanding of the market are crucial to consistent profitability.
Last year CNN Money reported that there are 141 privately held startups worth more than $1 billion in the world. The term “unicorns” is often given to these impossibly rare phenomenons. Private companies are valued based on how successful it raises money. If you’ve ever seen an episode of Dragon’s Den or Shark Tank you will probably see it in action. For example, if an investor agrees to pay $5 million for a 25% equity ownership in a startup then the company is said to be worth $20 million because 5 ÷ 0.25 = 20.
The popular ride-sharing company Uber launched its mobile app in 2010, and it’s latest round of funding already values it at over $50 Billion, making it the world’s most valuable startup! To put that into perspective, both GM and Ford are also worth roughly $50 Billion each. But GM and Ford are publicly traded companies and unlike Uber, they actually produce and sell real cars, lol. 🚗
Venture capitalists invest about $30 to $60 billion a year in the U.S. Although most venture capital (VC) funds aim to beat the conventional stock market most of them do not. However, top-performing VC funds have consistently outperformed the S&P 500 and Russell 2000, including across multiple vintages. This means finding competent managers is super important as the lion’s share of profits go to the top quintile of VC investments. So now that we know what VC is, let’s explore some options.
How Equity Crowdfunding Works
Crowdfunding sites are very popular. We’ve all heard of platforms like Kickstarter or Indiegogo. Most crowdfunding sites like these offer the backers rewards, goodwill, or swag, but not money. But other crowdfunding sites are created specifically for raising investments and act as financial brokers between investors and entrepreneurs. There are two main ways to crowdsource for investment capital; Equity Crowdfunding, and Debt Crowdfunding. For the purpose of this post we’ll just be looking at the former.
Equity crowdfunding is the online offering of private company securities to a group of people for investment purposes.
The way it works is that investors would give money to a startup that they want to back. Their money is pooled together with other venture capitalist and private equity firms. In return they receive partial ownership (AKA equity) in the business. The value of this equity will go up if the company succeeds, or go down if the company fails. Once the business grows large enough it would either be acquired by a larger firm, or file for IPO and become listed on the stock market. During this exiting process ownership of the company changes hands and the initial investors get their money back, hopefully with a decent profit. 🙂 An equity crowdfunding website would facilitate all of these transactions. It would be similar to Kickstarter, except backers receive equity in a business instead of a lame pre-order. 😁
There are a lot of equity crowdfunding sites to choose from. You can see a full list on Wikipedia. But below are some names that I’ve looked into so far and shorted listed for my own personal use.
- AngelList Only accredited investors can invest at this time. $104 million total invested sum.
- CrowdFunder For funding small and medium size companies. 12,000 investors. $100 million total invested sum.
- SeedInvest Mostly deals with tech startups. 100,000 investors. $50 million total invested sum.
- Wefunder Crowdfunding company in San Francisco. 70,000 investors. $22 million total invested sum.
Minimum investment is usually $1K or $2K but it depends on which website and even which specific company you want to fund. The following SEC regulations apply to all equity crowdfunding platforms in the U.S.
- If either your net worth or income are below $100k, you may legally invest up to 5% of the lesser number.
- If both your net worth or income are above $100k, you may legally invest up to 10% of the lesser number.
- No one may invest more than $100,000 per year, even for accredited investors.
Although there are lots of ways to invest in private companies not everyone should do it. As we’ll see in the following section, with high potential returns comes high risk and volatility. If you don’t like financial roller coaster rides then hold onto your stomach. 😰
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