PRIVATE EQUITY FACES THE PRICE OF POPULARITY

Think about a restaurant you love that suddenly becomes popular. While it’s nice to see other people catch onto a good thing, there are some drawbacks. Now you have to be sure to make a reservation well in advance, and perhaps you start going at off-peak times.

It doesn’t mean you can no longer enjoy the restaurant. It just means things have changed, and you have to adapt.

Popularity may also be changing private equity too, and this also calls for some adaptation. As with the restaurant example, this does not mean you have to avoid it, but it is important to recognize how private equity is evolving so you can consider approaching it in ways that minimize the potential disadvantages of popularity.

Is private equity going mainstream?

TIGER 21 Members have long recognized the value of private equity investing, and on average began making substantial increases in allocations to this asset class four or five years ago. Now, it seems, the wider public is catching on.

Secondary markets for ownership stakes in privately-held companies are increasingly opening the door for new entrants into these investments. While regulators have limited these markets to accredited investors, that limitation still represents a much lower threshold for private equity investors than, say, the wealth level of TIGER 21 Members. This means a broader audience for private equity, and that can change things.

Opening the door to a wider market for private equity investing may be part of the reason for the sudden boom in private equity valuations. As reported by The Economist, the number of U.S. private companies valued at $1 billion or more has jumped from 28 to 96 in just three years. One would like to think this marks an amazing period of true value creation for the economy, but the reality more likely is that growing demand for private equity investments is what is driving valuations higher.

Along with higher prices, private equity investors are having to wait longer for their investments to come to fruition. Since the beginning of this century, the average age of a company at the time of its initial public offering has jumped from four to eleven years. Investors getting into the game these days must be prepared to have their capital tied up for a longer period of time.

Higher prices and longer wait times – that takes us back to the restaurant analogy. Popularity is doing to private equity what it might do to a trendy restaurant, and investors who are not used to waiting at the end of the line have to think about how to adapt.

Possible implications

These changes give experienced private equity investors some food for thought. While secondary markets are still the exception rather than the rule, they seem to be catching on. Roughly half of the 25 most highly-valued private companies in the US now allow for secondary purchases and sales of ownership stakes, and given the competition among tech firms to accommodate high-value employees, this could become a broader trend. This trend could facilitate broader participation in private equity, but that would not be an entirely good thing. Commissions charged by market makers for this kind of transaction are very expensive, on both the buy and sell side. Plus, broader participation is likely to mean higher valuations.

Rising valuations make it imperative for an early-stage investor to be alert to overly-optimistic expectations on the part of later entrants. A flood of interest could drive a private company’s valuation up to where the reward gap between getting out early and waiting for an IPO is materially reduced. Bernard Baruch wisely advised that you can’t go broke taking profits. Sometimes, getting out of a private equity investment before an IPO can let you take your chips off the table at an opportune time.

The entrepreneurial touch

It is impossible to write an article recommending a single right way to deal with the growing popularity of private equity investing, because those investment opportunities are still unique enough that the impact of popularity will be felt differently depending on the situation. What could generally be an advantage for TIGER 21 Members is the entrepreneurial touch.

Entrepreneurial experience is helpful to private equity investing because people who have formed and nurtured start-ups of their own may be better at spotting viable early-stage investments. This allows them to avoid the valuation traps and added expenses that people now piling into later-stage private equity investments may encounter.

As private equity investing becomes more popular, more and more people who are used to passive public company investments will now be invested in private equity. However, investment without active engagement misses one of the great advantages of private over public company investing. As an outside investor in a public company you are among the last to know about a problem ‚Äì at which point it may be too late to fix. In contrast, a private equity investor can be one of the first to know of a problem or opportunity, and can help shape the company’s response to optimize the outcome. However, this only works if the investor is actively engaged with management.

Having entrepreneurial experience gives a private equity investor some business perspective that can help company managers get over some of the challenges they face in finding their markets and scaling their offerings. Often, successful companies catch on as something a little different from what their founders originally envisioned. Investors who can provide some advisory guidance along with their capital can help guide a developing company through the twists and turns of the early company life cycle. This is where many TIGER 21 Members have found the opportunity to have the greatest impact.

It seems that an entrepreneurial touch is especially valuable in light of how private equity is changing because entrepreneurs are not, by nature, passive investors. They anticipate changing conditions, and have a knack for adapting to and even benefiting from those changes. As people who are more used to passive investing start to pile into private equity markets, that entrepreneurial touch may become an even greater advantage.

Barbara GoodsteinPresident & CEO of TIGER 21