Investing in Private Markets - A Personal Perspective for Qualified Investors

I thought that for today’s piece I would focus on whether or not qualified investors, and experienced retail wealth individuals should follow the trend of institutional clients, particularly pension funds, and increase their relative exposure to private market assets.

Introduction

In this article, I am defining private markets to cover consideration of both direct exposure as possible through equity crowdfunding, direct offering to private angel investors via various types of distribution channels, and ICO token purchases, as well as through indirect, as available through listed venture capital trusts, off-market SEIS/EIS fund vehicle, and asset management vehicles that offer direct participation in new fund raising from traditional venture capital firms.

My own personal experience has focused on the former rather than the later so I thought to start with it would be worth me sharing my own personal experience to date. To give you some guideposts when I share my views, it is worth mentioning that my interface to private markets has been created through

1)    Being an angel investor that has been directly contacted by Fintech oriented entrepreneurs from time to time. In these situations, I was investing alone or among a very small number of other angels in a true start-up.

2)    Being a participant in an angel syndicate that represented about 15 wealthy individuals who had combined investment power of about US$25ml.

3)    Being a non-executive director in PE and VC backed firm who was offered an opportunity to invest alongside these institutions in both ordinary and preferred structures

4)    Being a strategic advisor for entrepreneurs bootstrapping scale-ups who offered me some reward for their successful exits based on accepting equity options in lieu of receiving payment

5)    Being an employee who was eligible to accept equity options in lieu of receiving any cash bonus within an executive management incentive arrangement.

6)    Being a member of equity crowdfunding platforms (both Crowdcube and Seedrs) and investing in private companies vis a vis these platforms (often after speaking with the founders themselves)

7)    Being a direct participant in new ICO token drops that have garnished high and very high interest among the crypto community, often acquiring eligibility through using Latoken.

Based on exposing myself to private markets based on these 7 different exposure channels, I have had, as I think every angel will tell you, a handful of legitimate home runs of which some would probably be considered grand slams (i.e. achieving returns that are well beyond those acquired via any public IPOs), a small number of crash/burn, capital write-offs, and a bunch of middling type of results (CAGR of between 5% after tax and 30% after tax).

The main takeaways that these experiences have offered to me so far are

1)    Angel investing in a vacuum or a small group to help a start-up entrepreneur without a lot of their own capital at risk is a “tough” road to travel on multiple fronts, let alone in terms of creating amazing financial outcomes that reward energy, time, and mental stress. I have lost more money being too early and too “hopeful” about big ideas that are really hard to execute, and in having too much faith with young entrepreneurs who don’t have sufficient experience in managing start-up capital. I have particularly learned why accelerator and incubator programs are so valuable for untested entrepreneurs, and why angels like myself should wait to invest in parallel or after entrepreneurs complete these courses, rather than before them. The individuals who come out the other side of these engagements, regardless of the mentoring and networking they acquire, usually exit with a far clearer vision on what they can execute, and how it can be marketed successfully to their addressable market.

2)    Investing via angel syndicates offers some protection over and above just mitigating the level of capital exposure and commitment. The major ones tend to be the ability of a network that has at least 20 members to help entrepreneurs with early deal making, market entry and senior recruitment.  I have had mixed experience in relation to how well syndicates help firms acquire venture backing or access to other forms of investment capital as companies begin to show some promise, but clearly as the size of a well structured syndicate grows, pure investment management talent for origination and curation is recruited, and aggregate capital gets above US$50ml, the syndicate starts to receive invitations to create their own dialogue with entrepreneurial programs and the seed investment community. This raises both the quality of the deal flow and also the level of due diligence that occurs prior to any investment decisions being taken.

3)    Buying into institutional financing situations has been the root by which I have created the maximum success for myself to date. I don’t think that anyone should find this surprising, but in my particular case, the important things I have learned are that

a.     To mitigate share class and the adverse impact of inferior rights one needs to be investing with the support of the management team and at the start of the highest risk taking cycle. This is when equity available is generally at its lowest price, and when outside domain advisors are most welcome and valued.  This often equates to late seed or Series A if possible or Series B for opportunities that are likely to achieve valuations well in excess of £250ml.

b.     One needs to carefully review how change/control situations and follow-up financing needs will play out as long private investment cycles normally will translate into both additional capital calls, and potential less lucrative forced liquidity scenarios for small investors operating outside of full employment conditions. This isn’t an uncommon risk to face, but it does mean that one always need to keep some investment capital toward the most promising private market exposures into reserve in terms of financial planning and cash flow management.

4)    Equity Crowdfunding is best undertaken in situations where one is capable and willing to underwrite an investment in excess of £10k, and in opportunities that aren’t too early in their corporate development cycle. While it always appears tempting to aggressively invest in lower valuation situations in very early-stage companies articulating very large global market opportunities, my experience is that companies that are funding in the £7-12ml pre-money range and have succeeded in growing to 12+ full time staff are the most likely to have the right sort of structural dynamics to attract the interest of venture firms. These firms tend to favor backing firms where the founders are trailblazers originating from highly respected academic roots or are individuals that clearly have investible track records of raising capital at higher valuations.

Taking the plunge oneself

When I am often asked about investing in alternative assets, I often start by talking about the risks rather than the rewards. From a risk attribution perspective, assuming that one is not restricted by minimum capital investment requirements, the biggest single variability to consider in the vehicle itself is liquidity. With the introduction of ICO and the availability of exchanges that are prepared to list a very large assortment of alt-coins, it is no longer true that liquidity and risk/reward go hand in hand, but generally speaking, my experience is that

1)    Direct investing offers the most positive return vs. risk capital ratio although secondary markets in ordinary and preferred share structures are still very fractured regardless of whether they are internally run or offered via equity crowdfunding platforms. Direct investing also suffers from usually exposing the client to the share class with the weakest protective rights, and this does offset some of the tax benefits that are derived through participating in the lucrative SEIS and EIS arrangements. My experience is that fund raisings in excess of £2ml via the nominee structure of the equity crowdfunding organization can provide some additional protection.

2)    Those thinking about direct investing as their primary means of exposure should be willing to accept a 5yr+ investment horizon as a minimum, and to expect that on a diversified portfolio based on industry and corporate maturity that investing £100k across 10 companies will at best yield two substantial winners, and that losses will come in advance of winners most of the time; pain will often, in behavioral terms lead joy!

In terms of originating direct investing opportunities for oneself, I would probably sound a strong warning about making any type of commitment via Linkedin invitations and would also be careful about offering that come via intermediaries unless they are exclusively focused on SEIS/EIS placements and have their own investment exposure. Equity Crowdfunding and participation through established angel syndicates that support direct investing would represent the two best options as far as origination vehicles go. I would suggest that even through these more established and professional investment channels, one should avoid both very small raises, i.e. less than £1ml and also very small liquidity events, i.e. less than 5% FDSO sales.   

For those who are looking to diversify their holdings in a more conservative fashion than the listed VCT are probably more suitable than placing funds into a SEIS/EIS asset managed fund vehicle. While the two structures do share a number of characteristics, and the later can often provide a better orientation in terms of investing thematically, the slightly negative bias I give to SEIS/EIS discretionary vehicles are as follows:

a.     They generally carry a more expensive fee structure and will have performance carry fee accelerators which can further reduce returns.  This can be particularly a drag on smaller investment sums, i.e. the 25-50k minimum.

b.     They often can be subscale in terms of their capital provision. This has two distinct implications; first, a smaller pool of capital often leads to the portfolio destined to have more concentration risk, and second, a smaller overall capital structure can hinder follow up investments. When certain segments, notably fintech, SAAS and healthtech are often seeing accelerated fund raising with significant valuation uplifts, too little capital and concentration restrictions will both be drags on return.

c.     They will be more actively investing in the very early-stage market than a VCT, and can often, as SEIS investors working with companies that will be in their first years of operation. There are tax relief benefits that of course accrue as a result of the higher risk profile for those who are able to work within the 3 and 5yr investment horizons, but there is also often less visible data to use for both commercial and financial due diligence purposes. Micro and Small company filings as well as exempt rather than full filings often reveal very little about financial performance, and only the most basic information about financial resiliency. This makes any type of realistic valuation exercise very difficult, and collateral financing almost impossible to achieve.

d.     The SEIS/EIS structure can often be structured to offer more concentrated industry focus than a VCT vehicle which is open to investing in a very wide pool of about 50,000 mid-market opportunities. The concentration that has been taken in relation to technology across a variety of sub-sectors has proven very lucrative for the past five years in line, but also carries greater risks on valuation inflation.

What should one expect

My capital exposure to private equity is currently about 20% of my total capital pool, and thus is fairly significant. When I think about what I should expect from this in terms of return contribution, I recognize

1)    Unicorn valuations and above currently are running at about 0.6% of venture funded vehicles on a global basis, and in the UK are at a lower level of 0.3%. 2% of the UK’s unicorns have come through equity crowdfunding, which means finding one through that smaller market is even harder. This does not mean to say that substantial rewards won’t be achievable relative to public markets as the secondary market indicators on Seedrs show, and the overall return profile on about 1/5 of the the 3000+  equity crowdfunding companies shows, but one will be far more likely to see success in the 5-50x range when it happens rather than 100x plus.

2)    Private Share investment is still a relatively nascent market, and while the liquidity pool is growing the chances of executing capital raise through the secondary market is still slim. I reckon based on crowdfunding data that we now have about 1-1.2ml direct investors in the UK, but this is still 7-8ml less than those who invest in the public market. Thus, one should always think in terms of holding periods of 5yrs+ and more probably 7-10yrs to maximize the return on capital. This isn’t too bad with some other types of alternatives such as wine for example, where I work off of a 20yr holding period, but still long.

3)    Investing in Private Shares that are eligible for investment via regulated venture capital firms and corporate investors isn’t a feature that is a given in every private capital fund raising. A lot of entrepreneurs don’t necessarily want to interact with institutional investors or aren’t equipped to do so. As such, backing individuals with this mindset will more often than not limit enterprise values to the £25ml to £150ml range. There are always a few exceptions that happen when businesses are led by real visionaries and disruptors, but one should always try to set one’s own expectations in an aligned way with those being backed.

4)    Investing in entrepreneurs who want to work outside of the traditional corridors that lead to more significant venture capital providers often offer much more to “add-value” angels, but also often end up asking for more from them. I have often been part of small domain investors who work outside of the mainstream, and while this was quite productive 5-7yrs ago, now that there are massive pools in the trillions of private equity capital, it doesn’t make a lot of sense to avoid where the big money is at, and it actually can be counterproductive to valuation growth.

I have also come to recognize since the middle of 2020 that ICOs, esp. those that have already secured support from the growing pool of specialist digital asset investment vehicles is a better mechanism for the high-risk portion of my investment capital than Equity financed start-ups. While the underlying financial profile of an ICO entity is often inferior and one is mostly investing in IP/Project concepts, I have come to realize that

1)    The quality of the due diligence that is now available on upcoming ICO has gotten a lot better and that at last we are seeing much more rigor going into the preparation of the ICO offering by the project team and its backers than was the case in 2017-2019. This is having a positive impact of the quality of the opportunities, as well as the definition of the project within the decentralized financing landscape. This is making recognizing peers much easier and also separating viable ideas from those with weak technical and business foundations a lot easier than 3yrs ago when there was a lot of bamboozling going on to attract inexperienced or naïve money.

2)    Badly articulated ICO issuers are being found out a lot more quickly when they are trying to use “false economics” and unsustainable tokenized incentives to fund a project. I still don’t think enough analysis is done on the economics behind a lot of ICO projects relative to their tokenization issuance, and distribution processes but poor offerings are failing a lot faster and reducing the opportunity window for scammers. One can however still get blindsided by innovative pump and dump ventures that never work beyond 60 days or so post issuance.

3)    The valuation jump that has been achieved in the top cryptocurrencies since 2019 has greatly expanded the pool of capital that digital institutional investors are able and willing to deploy into ICO structures, particularly when they are familiar with the players involved, and are redeploying digital assets into infrastructure services, and utility decentralized financial and blockchain capabilities. ICO can legitimately be created that re-define and enhance decentralized finance from an accessibility and usability perspective in ways that are much harder to find with pure equity start-ups. This translates into the prospect of much higher returns on capital invested which explains the surge in interest in legitimate business cases such as those accessible through NFTs and stablecoins.

4)    While the pool of investors in private shares is growing at something like 10% per annum, with the 30+ millions of people acquiring through one form or another a wallet for digital assets, ICO can tap into a much, much larger audience of customers who want to diversify their holdings, and are genuinely interested in Blockchain technology. Most of these investors don’t have an outlet yet to use assets in these wallets for everyday purchases in the real world, or use in a point of sales scenario that is economically interesting, so the focus on investing in more projects as a form of risk diversification as well as new rewards will certainly continue in 2022.

Conclusive Remarks

Private market investing is not on the whole advisable for those looking to achieve “quick returns”.  If one is however investing in the longer term and is considering a diversified strategy in relation to retirement than the presence of exposure to the private market makes increasing sense. Those who want to go through their own direct learning cycles should probably keep their initial exposure focused on a combination of involvement in equity crowdfunding and ICO projects based on some of the criteria above, while those who want a more passive approach should focus on including both VCT as well as listed private equity vehicles as part of their diversified self-invested pension portfolio structures.  The quality and return potential of private companies has always been a reality, but as with many other asset classes, positive changes in market structure, financial governance, and investment vehicles is now demanding real attention.