Five pitfalls to avoid in private market investing

Whether it be a European mRNA biotech pioneer, a US plant-based meat company or an Asian ride hailing business, many of today’s most profitable investments are found in private markets. Indeed, those that are successful deliver eye-watering returns to their sophisticated investors, some of whom are serial backers of start-ups. As Dr Giuseppe de Filippo, Julius Baer’s Head of Direct Private Investments, explains: “We are looking for companies that capture megatrends such as feeding the world without the harmful effects of traditional farming, or new medical technologies.”

In recent years, the growth in private investment opportunities has far outstripped that in stock markets. The number of private equity-owned companies increased by 10.7% a year from 2000 to 2018, compared with just 0.4% in public markets. Additionally, as companies choose to remain private for longer, they are turning to investors more times for capital to fuel development.

For wealthy individuals, private investments are becoming a key asset class. Over 80% of single family offices worldwide consider investing directly in private companies, according to research (Fintrx report). They invest across a broad range of sectors, preferring sectors capitalising on megatrends such as technology (see chart).

How to avoid common pitfalls in private market investing

While fast-growing companies exploiting megatrends can offer rich rewards, though, private markets are less transparent than regulated stock markets. In the pursuit of an investment edge, Giuseppe says there are several pitfalls to avoid.

First is a bias towards your home market or a particular sector. “Be open-minded to new ideas and new things; hidden opportunities in private markets can’t be found if you don’t search thoroughly.”
Second is investing in just one company. “You need to build your own basket so that you have some elements of diversification. For all the companies that succeed, some will fail.”
Third is being put off by the illiquidity of private markets. “Think about the comparison between fixed income, which is apparently liquid but will probably give you a negative return, and private debt, for example. If you invest in private debt you will be able to extract a higher return for less risk. While a bond may appear less risky, it will become illiquid in a situation of stress anyway.”
Fourth is investing in private businesses that have unknown advisers. “If a business is advised by a bank or accounting firm you’ve never heard of then alarm bells should go off. For example, with one UK firm we were looking at, we hadn’t heard of the auditor. Upon further investigation we could not locate an office or digital trace, so we terminated the transaction right there.
And, fifth, do not make rushed decisions. “Opportunities come and go. Do not invest without doing your homework, just because you fear missing out.”

Analyse all angles

In between meeting founders or investors around the world, Giuseppe enjoys photography. To his mind, the elements of a great picture also apply to the art of private investing.

Looking at all angles helps Giuseppe to select the businesses he presents to investors. Broadly speaking, from every 250 possibilities sourced through his professional network, he identifies 12 that have proven business models and a clear path to growth.

Initially, the businesses are screened using angles such as the experience of the management team, the geography they operate in and the funding stage. There is a preference for businesses servicing large geographical markets such as the US, Europe or Asia, as well as companies that are scaling up rather than pre-revenue start-ups.

After that, factors such as their competitive advantages and investment structures are reviewed. In the case of a regulated industry such as energy, the government’s energy policy would have a significant impact on the growth outlook. Alternatively, the fortunes of an ecommerce company selling clothing to the middle classes would depend on economic conditions.

Selectivity is essential

In a yield-starved investment world, the expansion of private direct investing is happening for good reason. “There are a lot more private companies in the world than public,” Giuseppe notes. “Also, companies are staying private for so much longer than before, so far more of their rapid growth happens outside public markets.”

Yet private markets are by nature opaque, and growth companies tend to be younger, which makes being highly selective especially important. For that reason, avoiding the pitfalls and analysing all angles is essential when seeking out high-growth businesses equipped to ride the megatrends.