MODULE 1
What are Private Markets?
  • Duration: 41 mins

What are Private Markets?

Assessing Risks and Returns

Whether we’re dealing with private markets or public markets, the phrase “There is no such thing as a free lunch” definitely applies. Different asset classes will offer you different kinds of returns. But none of it comes without a cost — there is always an associated risk.

It is very important to understand both the risks and potential returns so that you can get a complete picture. After all, the last thing you want to do is jump into something you’re not entirely sure of, that doesn’t have a clear risk profile.

Take, for instance, what happened to Julian Robertson in the year 2000. Robertson, the founder of Tiger Management, was a highly regarded hedge fund manager known for his value investing approach and his ability to spot opportunities in the market. But alas, the true litmus test for any investor is how they react during challenging times.

In the late 1990s, Julian made a significant and ill-timed bet against the technology sector. However, the technology industry kept getting stronger, and their bets went wrong. They lost a lot of money, billions of dollars, and had to shut down their company.

This unfortunate decision, while a rare stumble in an otherwise impressive career, serves as a reminder that even experienced investors can face setbacks when market conditions take unexpected turns.

And no investor would want that for themselves now, do they?

So in this chapter, we’re going to explore the main risks associated with alternative investments and we’ll also discuss certain strategies to combat them.

Understanding the Risk Landscape

Unlike public markets, private markets come with a unique set of challenges and uncertainties. After all, while the asset classes may be similar, the approach and the fundamental characteristics are innately different.

Private markets, for instance, are characterised by an information asymmetry. Because these companies are not listed on a stock exchange, it is not mandatory for them to declare their information to the public.

This is where the role of private market funds becomes more important. They can offer you an investment vehicle through which investors can participate in the private markets.

Main Risks in Private Markets

  1. Lack of Liquidity

    When you’re investing in an asset like public equity, it comes with high liquidity. You could, for instance, wake up one fine day and suddenly decide to sell your shares. All you’d have to do is place a sell request and it would get executed almost immediately.

    If it only were that easy in the private markets!

    Here, sudden exits are uncommon, to say the least. You should keep in mind that investments in the private market are generally meant for a longer horizon. It can range from 5-7 years, on average. In some instances, it can be even longer.

  2. Market and Valuation Risk

    This risk can trace its routes back to the lack of information in the private markets. After all, if you don’t know everything about the companies, then how can you decide what the correct valuation should be?

    Firstly, pre-profit companies are difficult to value, let alone pre-revenue companies. These valuations aren’t based on normal public market metrics. Instead, you have to consider the future prospects of the company, which is quite difficult, to say the least.

    Secondly, it is not like the share price of private companies is public information. This means that you have to access the companies first-hand to obtain information. This is a hands-on job, not a desk role.

    Thirdly, there is a lack of frequent price discovery. After all, there is no daily trading like in the public markets. This means that valuations can get out of date. For buyers in the up-markets, this can be advantageous, but not for those in the down-market. It is very important to keep reviewing the market conditions and update the valuations at periodic intervals.

  3. Operational Risk

    Private market funds generally take quite an active role in the oversight and guidance of portfolio companies. GPs, for instance, can participate in the business strategy and decision-making process.

    Startups, in fact, can benefit from the expert guidance that the GPs can provide. They can also use the extensive network and connections to market their product and attract funding.

    This involvement has its own pros and cons.

    On the plus side, it gives the fund greater influence over the portfolio company. They can keep a close watch and ensure that the startup stays on the right growth trajectory. They can also help the startup create a strong competitive moat that will ensure its consistent performance even in the future.

    However, the need for active ownership and operational involvement makes it clear that the fund is exposed to operational challenges within its portfolio companies. The fund managers may have to deal with many unforeseen events that can have an adverse impact on the portfolio company or the fund as a whole.

  4. Macroeconomic Factors

    Most investments, whether in the private markets or in the public markets, are influenced by macroeconomic factors. This can include anything ranging from broader economic trends, interest rate fluctuations and geopolitical events.

    For instance, if there is an event like the COVID-19 pandemic or the Russia-Ukraine war or rising interest rates, the markets are jittery on the whole. Investors automatically become more cautious and think twice before deploying capital.

Risk Mitigation Strategies

  1. Diversification

    Yes, even in the private markets, a strategy as simple as diversification can help reduce risk.

    Diversification begins with funds. A fund may invest in anywhere from 30 companies (early stage) to 8 companies (LBO).

    GPs deploy the fund capital in a number of investments in different companies. It ensures that if some of the portfolio companies don’t perform as expected, the others will mitigate this risk.

    LPs can take diversification further within their portfolio of private market investments by investing in multiple funds across different stages such as Seed, A, growth, PE and venture debt, and across different vintage years.

  2. Due Diligence

    This is critical, especially in the private markets.

    At the GP level, because there is an inherent opacity that characterizes private investments, the process of due diligence before investing in individual companies is exceedingly important. After all, once you’re invested, you’re stuck.

    Fund managers generally use an extensive due diligence process. This involves assessing the financial health, management team, competitive positioning and growth prospects of the target companies.

    For LPs, the careful diligence of private market funds is important because the spread between top and bottom-performing private market funds is much wider than it is for funds investing in public markets.

  3. Exit Planning

    Having a well-developed approach to exit planning is vital. After all, unless the GPs exit from the portfolio companies the investors will not be able to realise their profits. This strategy should align with the fund’s objectives and timelines.

    The exit strategy should balance the need to ‘de-risk’ the fund by getting investors’ original capital back to them (fund DPI of 1x) and the need to achieve the fund’s ultimate return objective.

    Ideally, of course, the exit should come at the right time, when the startup’s valuation has increased. In some cases, however, especially if the startup fails, the exit strategy can help preserve some of the capital.

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