How does it work?
Of course, most companies are not listed on an exchange and part of the stock market. The majority of businesses are private and owned by a limited number of individuals or institutions. The term Private Equity refers to investments in such private firms. Venture Capital is essentially a subcategory of Private Equity and relates to investments in young, not yet established businesses (start-ups). Private investments are usually only available to professional and institutional investors either directly or through special investment funds. Nevertheless, some corporations listed on the stock exchange whose business model is the pursuit of investments in private companies. By buying the stocks of these companies, investors can obtain indirect exposure to this asset class.
How do they make money?
Fundamentally, Private Equity and Venture Capital investments are not different from investment in public equity. This means the investor acquires (fractional) ownership in a corporation and, in return, has the right to vote on business-related decisions, including the distribution of profits through dividends. The most crucial difference is that private businesses are not traded through an exchange. This implies that there is no daily valuation of the company, and investors cannot simply buy and sell their shares. Instead, they need to find a willing buyer or seller, which can take time. Private Equity and Venture Capital investors also tend to acquire more significant stakes in the target businesses, which allows them to exert much more influence on its management (for instance, by taking board seats). Professional Private Equity and Venture Capital investors usually try to improve the performance of their investments by bringing in their own know-how.
For smaller investors, investment funds that pool money and invest it on behalf of them are the most common choice. Unlike funds that invest in public stocks or bonds, these funds have a fixed lifetime and are closed throughout. This means the investor commits capital for a pre-defined period and can’t access it in the meantime.
How risky is this asset class?
Private Equity and Venture Capital investments tend to be riskier than investments in public stocks but have historically also delivered higher returns. This has several reasons. First of all, the fact that the asset can’t be bought and sold quickly means that investors face the risk of not being able to access their money when they need it (illiquidity). Furthermore, professional Private Equity investors tend to focus on businesses that are somehow struggling and have the most significant potential for improvement. It is also common to take on debt (leverage) to finance acquisitions of private businesses. This debt acts as a lever for the investor’s return on equity (ROI). If the target business performs well, the investor can pay a big dividend on a relatively small base of its capital. However, if the target business performs poorly and only pays small or no dividends, the investor must make fixed interest and principal payments to the lender.
Venture Capital investments are inherently risky because the target businesses (start-ups) are young, small, and often still loss-making. This means there is a high likelihood that the company ultimately fails, for instance, because the spotted business opportunity is just not there or because there is an unexpectedly intense competition, or because the management and the operational team fail to execute its plans. It is estimated that around 30-40% of US start-ups eventually loose all their money while 95% don’t manage to deliver the promised returns. However, the returns generated by the small number of successful start-ups are often huge (think of companies like Facebook or Google). This is why diversification is essential. Professional Venture Capital investors usually invest in dozens or hundreds of start-ups and actively help them develop their businesses. This allows them to offset and overcompensate the losses from many failed investments with the enormous gains from a few successful ones.
Why is it important for my portfolio?
Private Equity and Venture Capital investments can help your portfolio achieve higher long-term returns. It is generally assumed that the illiquidity of private investments results in a return premium. This means because these assets can’t be bought and sold as easily and quickly as listed investments, they are cheaper relative to the profits and dividends they generate. Over time, this results in higher returns.
Therefore, private equity and Venture Capital are especially interesting for long-term-oriented investors who don’t mind committing a part of their capital for a longer period. Some institutional investors, such as the Yale Foundation, have become very successful and famous by relying heavily on illiquid assets.
How do you approach private investing?
At Amadeus Capital, we have been investing in Private Equity and Venture Capital for decades. This includes direct investments sourced through our network as well as indirect investments through funds and listed Private Equity firms. When we discover a promising direct investment opportunity, we generally assess it carefully and build a complete financial model to value the business. Depending on the suitability of the investment opportunity, we then offer interested professional clients the opportunity to join us. We generally invest alongside our clients to ensure perfect alignment of interests and don’t pitch investments we would not pursue ourselves.
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