Are You Aware of the Risks in Private Markets

Takeaways

• What are private markets

• The risks that no one is seeing

• How you can respond

What are private markets?

Private markets bring together investors and companies looking for capital, but everything is done in private behind closed doors. This is contrary to public markets (I.e. the stock market) where prices are publicly agreed and listed. It also means that terms of any deal can be kept client if all parties wish for it.

Historically if you want to raise capital you go to public markets. This is because this was the easiest and in many respects the only place to find new capital investment. With interest rates so low, it became easy to find capital privately.

As a result many firms chose not to raise capital through public markets. Indeed, by staying private for longer, companies avoided the scrutiny which comes with public listings. Facebook was an example of a company which went through multiple private funding rounds.

Another reason why private markets grew was the many sovereign wealth funds looking to take large stakes in companies. This created a perfect situation where large amounts of money flowed into private markets.

For individuals looking to gain access to private markets, this is often achieved through listed PE funds or mainstream funds which are allowed to invest a percentage of their funds in private markers. (These are also known as unlisted investments).

What is the problem with private markets?

As large amounts of money entered private markets, this drove up prices. This resulted in many transactions being entered into at valuations which were not realistic. As deals were entered in private, there is no day-to-day valuation, something which public markets would give you. This means that any problems with the value of a company may not yet be immediately apparent.

Why is this a potential problem?

Because it creates a multitude of other problems. First and foremost, it means that any investment you hold in a privately listed company is likely to be worth considerably less. As these investments are privately listed, it is not easy to sell them. Indeed you may find occasions where you are unable to sell them. Worst, some private investments may not be able to be sold for a significant period of time due to previously agreed lock up period.

Another problem you have is that as some privately-held companies are revalued downwards, this has a knock-on effect with other companies. As a result, investors who may be initially inclined to invest in new funding rounds may not. Worst they have push a harder bargain, pushing down the value of the company even more - to your detriment.

Are there examples of companies losing substantial value?

The warnings have been there for a long time. The most famous one of modern times was WeWork. This desk leasing company had a sky high private valuation which was burst when it listed publicly.

More recently, Klarna has had to accept that the valuation it was given by private markets was no longer the same. Although there was a combination of  factors for this, the lack of public scrutiny (through pricing on a public exchange) meant it was allowed to gain an impossible value. Not to mention a business model which will struggle with increasing interest rates.

How will those running private markets respond?

There is a play book that many badly performing funds will turn when their private market investments turn sour. Firstly they will admit to nothing. If pushed they will only mention that it is short-term problems. They will do their utmost to hide the loss of value.

On some occasions if there is a capital raising, then details will be kept as quiet as possible to ensure that the current valuation can be maintained. Admitting that you have had to raise money at a lower valuation can be seen as a disaster. This may not always work, but you should be aware that it does occur. Cynically, this ploy may work in your favour. If a rival fund admits publicly to a problem, it was be revalued downwards, whilst your investment 'keeps' its value!

Finally, the portfolio managers concerned will hope and pray for markets to turn in their favour. As a result they will not have to admit that their decision making was poor. If an investment looses a great of value in a volatile period but you do not have to admit to it then they can keep their 'reputation'.

What can you do to protect yourself?

Firstly understand if this is the right asset class for you. You may find that the illiquid side of this asset class is not possible for you. This is particularly the case if you need income, as typically with an investment in the private market space, your money is 'locked up' for a couple of years before it becomes liquid/profitable.

Due to the downside risk it may be sensible to keep a margin of safety by not investing more than 5% of your investments in private market focused funds or investments. Also analyse what kind of private market fund it is. Is the Softbank scatter gun approach? Or a more diversified approach where a portfolio of investments are held with each investment limited to 5% of the fund?

Conclusion

You have to understand that portfolio managers who should be acting in your best interest are not. If an investment in private company goes wrong they will not admit until the last moment that they are loosing you money, loosing you even more money. You should therefore stay aware and be prepared to research for yourself what the true value of your investment is.