MARCH 2020

The Case for Private Markets

excerpts - by Jason Frishman

Recent stock market declines in response to the uncertainty arising from the spread of the novel Covid-19 Coronavirus have caused many investors to reassess their portfolios. Stocks have been sold at the fastest rate since the financial crisis of 2007-2008. Investors seeking the relative safety of U.S. Treasury bonds have bid their prices up, driving down yields to historic lows.

In such uncertain times, where risks abound in any investment opportunity, investors should consider allocating capital to invest in the private markets. If you are taking risk investing in public or private equities, you should consider taking the risk which comes with the possibility of an outsized return. Those wild price gyrations of the public markets -- down several points one day, back up another, only to plummet again the next -- really unnerve most investors. And when the declines get as bad as they have recently, many investors throw in the towel and sell, fearful that more pain is ahead.

Publicly traded stocks face a double whammy when a market disruption occurs, such as the Covid-19 outbreak. As forecasters begin to talk about a looming recession, investors anticipate declining earnings, and are no longer willing to pay a lofty multiple for those earnings. When multiples contract, a stock whose earnings decline by X may see its price decline by 2X, or 3X, or even more.

Not so in the private markets. Entrepreneurs looking to raise capital for their private businesses offer investors shares in a portion of the company that reflect its value at that time. Investors are attracted by the opportunity to get in early and hold shares in the hope of a future reward -if the company goes public or gets bought out at a premium. Shares are not traded publicly so they are not subject to the volatility that comes from waves of investor panic and pessimism when broad market conditions deteriorate. It’s the ultimate buy and hold strategy, which many veteran investors say is the best way to build wealth over the long term.

The mainstream media and Wall Street analysts would have investors believe that public stocks are far safer than private stocks. But recessions like Covid-19 and scandals like Enron continue to prove the truth: there is risk everywhere. Some investors choose an asset which offers outsized returns like private market stocks, where one’s money can make a difference in the company being invested in, and create real value in the world.

For many years, opportunities to invest in private companies were restricted to accredited (high net worth) investors and largely controlled by venture capitalists and private equity firms. But this all changed with a new regulation under Section 4(a)(6) (Reg CF) of the JOBS Act, which allows investors of any means to invest in private companies. Under this regulation, private companies offer their securities in various formats - events, online, or pitch panels - which enables these investors to participate

Owning securities that are not publicly traded comes with a small cost – a lack of liquidity. This can be a dual-edged sword. Investors like to know they can have access to their funds, but they can also have a tendency to sell stock at inopportune times during market panics. Nonetheless, personal circumstances can change over time and make illiquidity a problem for an investor. While early stage private companies may be immune from the risk associated with trading volatility, they are a riskier proposition than larger, more established companies. Not all startups will succeed. So as one dives into the world of private investing, it makes sense to keep some basic principles in mind.

Number one: diversify. Investing in multiple offerings decreases your specific risk in any one investment.

Number two: assess your tolerance for risk. Don’t allocate more to higher risk investments than you can afford to lose.

Number three: think long term. Investing in early stage companies creates the opportunity to participate in significant growth, but investors should expect it may take several years or more for such an investment to pay off.

Keeping those principles in mind, there is no reason an investor should not consider private market investing as part of a broadly diversified portfolio.

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