Aug 082016
 

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! 🙂

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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.

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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.

 

Venture Capital vs Stock Market Returns

The National Venture Capital Association released a report last year comparing VC returns to that of U.S. stock benchmarks. While all three major stock indices in the U.S. tied or outperformed venture capital investing during the 3 and 5 year period, venture capital outperformed the Dow Jones, Nasdaq Composite and S&P 500 during the longer 10, 15 and 20 year horizons. As a growth investor I would put more weight on the longer term results.

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The average 10 year annual return for the three “U.S. Venture Capital” indices work out to 10.8%, which is quite acceptable. These are pooled net returns to investors. The full 27 page report can be downloaded here (PDF file).

Another report from OMERs Venture based in Ontario, reached a similar conclusion. It mentions that $1 invested in 2004 in an average private equity fund would have been worth $3.13 at the end of 2015 (10.9% compounded annually for 11 years), versus $1.79 in the S&P500 (5.4% compounded annually for 11 years).

Returns for VC in particular are extremely volatile when compared against established private equity or public markets. Here’s a chart that shows the past performance of venture capital investments (red bars) compared to the general private equity market, as well as the S&P 500 stock market index.

private equity returns vs venture capital and stocks

Yikes! As we can see VC returns can vary dramatically, lol. But that can be advantageous because it represents a weak correlation to the public stock market, with a coefficient of just 0.37 according to the report, which statistically speaking is a small positive relationship. So holding some VC investments could help to smooth out a portfolio during rough times in the economy. Volatility also raises the chance of a huge return, without exacerbating the worst possible outcome because we can never lose more than our initial investment.

Keep in mind that the S&P 500 performance in the chart above is measured in vintage years. This means in any one year the investment is seen as being held for the duration of a typical VC position and the returns are calculated accordingly. This makes for a more balanced comparison. 🙂

The most thoroughly researched paper I’ve found on VC investing is a working paper titled “The Risk and Returns of Venture Capital,” by John Cochrane from UCLAwhich is actually what happens when the fog clears in Los Angeles. Haha! high five if you got that joke.

Anyway, he analyzed about 17,000 financing rounds across 8,000 companies, representing $114 billion of investments between 1987 and 2000. About 15% of companies that successfully exited returned more than 1,000%. 😀 But at the same time 15% of exited companies delivered negative returns. Good golly. 🙁

His research paper isn’t completed yet but after controlling for selection bias the author does tell us that the “most probable” outcome for these types of VC investment is about 25%. But keep in mind this conclusion is from data over 15 years ago. Here’s a smoothed histogram of distribution of net returns. (It doesn’t represent annualized returns.)

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For the nerdy masochists out there, you can download the full 41 page report here (PDF file,) complete with advanced algebra, log equations, and CAPM regressions.

 

The Drawbacks of Venture Capital and Private Equity

The VC environment is full of success stories and amazing anecdotes, mostly because those are the stories that make it into the media. But the plural of anecdote is not fact. So we should keep our expectations in check.

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Everyone wants to get in on the ground floor of the next Groupon, Zynga, Skype, or Uber. The initial investors in each of those companies made profits over 100 fold. We all want to invest in a unicorn. But if we look at the actual data of VC investments we see some troubling disadvantages. Here are the more significant risks that I’ve noticed.

  1. Ludicrous valuations. – It’s feeling more and more like a bubble in the startup landscape. Even one of Uber’s own investors, venture capitalist Bill Gurley, admitted in a Wall Street Journal conference that “all these private valuations are fake.
  2. Lack of liquidity. – Once invested, our funds would be held for 5, 7, or even 10 years.
  3. Technology risk and market adoption risk. – Unlike an established publicly traded company, startups are young and inexperienced. We don’t know if the final product or service will work after it’s built. And we don’t know if customers will actually buy it.
  4. High chance of a major loss. – Anywhere from 75% to 90% of startups ultimately fail.

Venture capital certainly isn’t as lucrative as it once was a few decades ago when there was less seed money chasing after startups. Investor Tucker Max wrote a cautionary piece in the Observer explaining why he quit investing in startups and why people should never start. He elaborates that “the economics of angel investing works against all but a select few.”

It’s only the Beginning

This has been an overview of investing in private companies. We’ve only scratched the surface, but much like Satan’s resume, the devil lies in the details, which we’ll get to next time.

I’m currently researching different crowdfunding platforms. The idea of being a silent partner in a startup company with the potential to hit a home run is really appealing to me. Most startups fail within their first two years of operation. But if I can buy a basket of them, much like an ETF, then my risk should be reduced. 🙂 I have spoken to representatives from the crowdfunding websites I’ve mentioned above. I told them my concerns and ask them some questions. If I do decide to put money in venture capital, I would limit my exposure to less than 10% of my investment portfolio. I’ll update you guys as I get more information. 😉

Some folks would say that Uber’s valuation is absurdly high. And I have to agree. But let’s put things into perspective. Facebook went public in 2012 with a $104 Billion valuation. Today, just 4 years later, it has more than tripled in value and has become the 6th largest corporation in the entire world. It’s currently worth about $360 Billion! I mean WTF? It has a market capitalization that rivals tech giant Amazon.com, energy titan ExxonMobil, and Warren Buffett’s company, Berkshire Hathaway.

The inflated stock market does not diminish the argument that private companies like Uber are insanely overvalued. But my point is we should look at the bigger picture. 🙂 If the S&P 500 were to plummet again like it did in 2008, then it may not be the worst idea in the world to maintain a small portion of our wealth in private businesses, which historically have a low correlation to stock market movements.

Ultimately venture capital consists of investing in growth-oriented, innovative companies that can play a meaningful role in reducing portfolio volatility, and increasing returns. Despite the risks, I believe VC can be a worthwhile and strong performing asset category for investors like myself who are looking to “venture” into the world of private businesses ownership.

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Random Useless Fact:

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11 Comments on "How to Make Money in Private Equity"

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Financial Canadian
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Keep us posted! I find this very fascinating and will possibly consider deploying capital into this strategy in the future.

FerdiS
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Great post about VC through crowd-funding. I’ll reference this post in future, I’m sure! Thanks for compiling!

Mark
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Mark

It’s important not to confuse private equity (leveraged buy-outs of established, cashflow-positive businesses) with venture capital (accelerative funding of existing but not-yet-profitable firms) and seed investing (start-up money). Private equity delivers greater returns than the public markets, whereas venture capital and seed investing on average generate negative returns.

Investors can access listed private equity via the public markets, on both sides of the Atlantic.

Anon
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Anon
Oh my. Where to begin. I’ve got about eight years of Private Equity study and work under my belt, and I will state with high confidence that almost no retail investor should engage in PE investments (that includes CF and VC). Modern VC firms have a much more difficult time picking winners than 15-20 years ago…and if the pros can’t do it with a great degree of consistent success, anyone on the outside of the industry is destined to fail. The first PE firm I worked with had a shelf of about 20 companies when I joined. Their historical aggregate average return for their clients was ~8%. A terrible return considering the risks involved. As Mark commented, if you really feel the need to jump into PE, there are plenty of public listed PE vehicles around. Take Canada’s own ONEX (OCX), which is a huge ($8+ billion) private equity company, and available for public investment on the TSX/. Over the last 15 years their public stock — driven by private equity investments — has returned ~12.25% year. An awesome return considering the risks involved. (As a side note, the founders of ONEX made 50%/yr return while they ran it as… Read more »
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