How to Invest in Private Companies
The U.S. stock market is watching a troubling trend; public companies appear to be losing ground. Lately, many of us admit that some businesses would be better off as private companies. Indeed, private companies historically proved to be a better option when talking about investment rate. However, the alternative market is difficult to access for retail investors. Most private companies are just that, private, and out of reach of the most well-heeled investors.
But there are ways for ordinary investors to get into the private equity realm, as many family offices did in 2017-2018, getting on the direct investment or co-invest deals.
Investing in Private Equity Companies
The investor can buy the stock of private equity companies that are themselves publicly traded. For example - Fairfax, Onex Corp., Brookfield entities or Berkshire Hathaway. Instead of manufacturing or trade of goods, the private equity players buy other companies or infrastructure assets, to hold them long-term or turn them around for a sale. Usually, these entities invest in a private portfolio of companies. This is an option for ordinary investors to get into this market.
Another way is to invest directly in a private company. There are a handful of benefits. Despite public firms that are focused on quarterly results and short-term expectations, private companies do not miss out on long-term value-creating opportunities, such as investing in a product that may take years to develop, thus hurting profits in the near term. Private firms can be better managed for the long-term and generally have increased productivity, also can create more jobs and are run more efficiently and profitably. Being an owner of a private firm means sharing more directly in the firm's profits. Earnings may grow at a private firm and can be paid directly to the owners. Private owners, if they wish, can have a role in the decision-making process of the company, especially the ones with large ownership stakes. However, if the managing team is good, they would rather stay idle.
Private Equity - Good or Bad
A basic research will suggest there are good reasons for getting exposure to private equity. Most of us know that private firms grow faster than public ones. The average rate of return for private equity is nearly twice as high as public firms—7.2% compared to 3.6% of total assets per year. Private companies’ investment decisions and dynamics are five times more responsive to changes and opportunities than public counterparts.
3 reasons why private businesses grow faster
Public companies have Limited Flexibility, the inherent conflict of interest between executives wanting to create wealth for themselves and doing what’s best for shareholders. And because people can sell stock at any sign of trouble, this weakens the incentives for effective corporate governance. Publicly traded companies have a lot of bureaucratic work to execute, their structure making them slow and of course, they have people to report, and answer to.
The Management Team of public companies most of the times avoid making investment decisions because they don’t want to cause stress.
The short-term policy is the focus on short-term profits. This has the biggest effect on private versus public company returns.
"Public businesses are under quarterly scrutiny, so the pressure is on. Private companies can make investment decisions with less layers of control and less or more efficient examination.", says Daniel Varzari, CEO of DVG GROUP CORP
"If one would ask if benefits of owning a private company get passed on to private equity investors? Sure, in the form of dividends, capital appreciation, and share buybacks. The business is the same as real estate investment trusts. It is similar to investors who buy a listed REIT on a stock market, he gets exposure to quality real estate assets. One must buy stock of a publicly listed private equity firm to get access to private businesses."
"Most private equity investment companies don’t pay REIT-like dividends (90% of income has to be distributed to holders). Berkshire Hathaway pays no dividend at all, and Brookfield Asset Management has a yield of 1.52%. However, their assets tend to perform better and see higher returns during certain times."
"The S&P Listed Private Equity Index tracks the performance of publicly listed private equity operations. The index is up 34% over the past 12 months and has a 19.72% five-year annualized return. That’s better than both the S&P 500 and the S&P/TSX composite index’s returns. When times are tough and private company performance takes a hit, though, these stocks can fall hard. These are for people who are looking for something to juice returns as you are taking on extra risk."
In private equity, one has to accept less transparency. The investor won’t get the quarterly disclosure and performance as in the public market. The managers in PE are not required to meet sales targets every quarter, and they can make drastic operational changes if they need to. The company’s cash is formed from dividends paid out by the held portfolio. Some PE companies will collect fees for managing assets shared with institutional partners. But the big cash comes when the holding company sells the asset.
Direct investing -
how do you invest in private companies?
Direct investing is the scenario when an investor directly invests in private companies. One could buy the entire company or a minority. High Net Worth Individuals invest in private companies to diversify their portfolios. According to the research by Institute for Private Investors, those with $20 million or more in assets allocate on average 4% of their portfolios to direct investments or investments in private companies. Online platforms are giving investors access to a wider variety of private opportunities than was previously accessible.
Past performance is very important for the future. One shall look for a history of good returns and management continuity, and how the management handles in downturn situations. Private equity or direct investment isn’t necessarily better than the other, but a more focused approach could perform better if one poses the knowledge. A good recommendation is investing no more than 10% of your portfolio in these types of businesses. Cautions because of strong year-to-date gains, there could be a short-term pullback. "And not only, as we expect the next crisis next year, and the optimism killer shall also readjust the stock market with a fall of 15-20%." Asset prices will fall, creating the best terms to invest in private holdings that will appreciate for the next 8-9 years.