Alternative Investments: Deciding Whether to Invest Directly in Private Companies

Private markets have proven to outperform stock market investing in years where the stock market has been strong, but even more so in down years for public equities like we are currently experiencing here at the start of 2023. “If public stocks are returning 15% a year or more, private equity may only deliver another [extra] 1% to 1.5% a year, on average, but when markets are negative or in single-digital territory—which many analysts forecast for 2023—private equity outperforms by 6% to 8% on average.” (Source). At the same time, individual investors are historically “underinvested” in alternative investments like direct private company investments as compared to institutional investors. While “[i]Institutions typically invest between 30-50 percent of their assets in alternative [investments] . . . the average high net worth investor has just 2% of their portfolio in alternatives,” says a recent piece in the Financial Times citing a study from McKinsey & Company. High-net-worth-investors (HNWIs) should be well-prepared to make capital allocation decisions into alternative investments if they like this asset class.

Source

A few threshold questions for investors, however, are worth considering before allocating a significant amount of their portfolio to private company investments. For example, is doing the diligence and taking the risk for the additional upside available in private market deals worth it? Can you even get your hands on good or great opportunities in private companies? If you can, is the expectation of an additional return worth the uncertainty of navigating the private company investment landscape?

Through ups and downs, the S&P 500 has generated an average annual return on investment of 9.56% over the past 30 years dating back to the early 1990s. Having traversed the market volatility of the Dot-com bubble, the 2008 financial crisis and the COVID-19 initial sell-off and subsequent bull rally, a near 10% percent annual return in the S&P 500 is a meaningful and tough-to-replicate figure especially on a risk-adjusted basis. In playing the game of probabilities, which investing necessarily entails, it only makes sense, from our perspective, to go after direct private investments that can return substantially above the amount that you would reasonably expect based on historical indicators if you simply purchased a low-cost index fund tracking the S&P 500 and then patiently waited for its average returns.

How much more potential return you should demand in order to make the move to, or invest more heavily in, private companies is a personal decision. In our case, speaking both as investors and from the perspective of our firm as a capital allocator, to invest in a private company, we need to see (1) a significant price discount to the current intrinsic value of the private company equity that we are purchasing and (2) the potential based on the valuation of the business at time of purchase and its future prospects to have the chance for several multiples on our capital in a reasonable period of time; a slightly higher annual yield than we could get in an S&P 500 Index Fund won't be enough.

Big wins have to be a reasonably probable outcome in private market investing. Some investors choose to analyze “Risk Premium" and use “Capital Asset Pricing” models to determine how much yield private placements in private companies should reasonably deliver to be justifiable investments in comparison to fixed yield or more predictable asset classes. We feel that resorting to formulaic, purely quantitative assessments of future outcomes is a flawed approach to investing: if you have to employ complicated formulas to determine whether a private market investment is better than a wholly passive public market opportunity then you are likely cutting it too close to justify the private company investment. Why chase basis points of return? Making this discussion a bit more concrete, our firm at Legacy Group does not invest in any private business that does not have a reasonable path to generating a return of $5.00-$7.00 for each dollar invested within five to seven years.

The next threshold question for deciding whether to even look at alternative investments is to ask, from a personal perspective, whether you want or need to invest in private businesses based on your investing goals. Sometimes, the motivation to pursue private deals over public securities is a distrust in public markets. Other times, the rationale is that you can get access to private deals on privately-negotiated, beneficial terms that can only be realized in the private markets. Of course, not all investment opportunities are created equally. Different private market opportunities can serve different purposes. What are you looking to achieve with a greater allocation to private companies? Some rationales can be cash flow or wealth creation through high prospect growth businesses. Know the reasons why you are wanting to allocate more heavily into private companies before doing so to make sure there isn't an easier, more proven method for meeting your goals.

While the investment portfolio of our firm is limited to private markets because we believe the opportunity for favorable outcomes far exceeds that available in public markets, we do think it is important for investors to engage in the personal interrogatory above before committing any effort or capital to private placements. For investors who have decided to invest more in private companies, we love the long-term return potential of the asset class. 

About the Authors

Cole Shephard is the founding partner of the alternative asset manager, Legacy Group, and the founder and a board member at the Green Coffee Company. As a former PwC alum working in accounting, advisory and consulting solutions across the United States, Bermuda, Hong Kong and Beijing, Cole is an expert in emerging markets and understanding the capital movements of high-net-worth investors.

Adam Jason is a partner at Legacy Group and a board member at the Green Coffee Company. He is an attorney specialized in corporate finance, governance, securities regulation and international business transactions. He has advised Fortune 500 companies and investment banks, including JP Morgan, Morgan Stanley, Citibank and Goldman Sachs, through initial public offerings (IPOs) and offerings of debt and equity securities exceeding an aggregate of $10 billion.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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