We’re all searching for ‘the next big thing.’ One potential way to capture upside in a company is by investing before the company IPOs (AKA goes public). With more companies choosing to stay private for longer while they grow their operations, pre-IPO investments through private equity and hedge funds offer the opportunity to capture such upside during this stage. Whether it was the IPO of Uber, Snapchat, Snowflake, or, more recently, Bumble, there has been no shortage of public market debuts in the past few years.

Source: Institutional Investor, June 2020. “The Existential Crisis Facing Long-Short Equity.”

The number of publicly listed firms in the U.S. has fallen sharply, while the number of private firms has steadily increased. The trend is similar in other countries, including those in Europe. Robust merger and acquisition activity, including leveraged buyouts, has led many firms to be consolidated.

Other reasons include a rising regulatory burden on publicly listed companies and the availability of private capital. In the past, many companies had to go public or tap public debt markets to access financing. But private funds now serve as meaningful sources of capital.

As a result, many companies are electing to stay private for longer. Many of these companies are leaders in their industry, and some have strong cash flows and limited capex requirements. And the secondary market is growing, whereby eligible private investors can sell their ownership stakes to others.

Source: BlackRock, December 2017. “Extracting Returns in Private Markets.”

Private equity continues to perform well, outpacing other private markets asset classes and most measures of comparable public market performance. The strength and speed of the rebound suggest resilience and continued momentum as investors increasingly look to private markets for higher potential returns in a sustained low-yield environment.

First, private equity has outperformed reasonable public market benchmarks over the last five-, ten-, and 20-year periods. On a pooled basis, private equity has produced a 14.3 percent annualized return over the trailing ten-year period, beating the S&P 500 return of 13.8 percent by 50 basis points (through September 30, 2020, inclusive of vintage years 1978–2017).

Over the trailing 20-year period, outperformance has reportedly been even greater. Private equity has produced a 9.9 percent annualized return, beating the S&P 500 return of 6.4 percent by 350 basis points (through September 30, 2020, inclusive of vintage years 1978–2017).

Without belaboring the analytical choices, in-depth research from McKinsey & Co. shows that private equity has continued to outperform public market equivalents (PME), which is the most commonly accepted measure of private equity performance as it considers the timing of capital calls and distributions. By synthetically investing those cash flows into public markets, PME creates an equivalency on which to compare performance. This conclusion holds over multiple time periods, compared against both large-cap and small-cap benchmarks.

Private equity has outperformed certain alternative asset classes and has experienced less volatility since 2008.

Large private equity firms, hedge funds, and other institutional investors who have unmatched resources, expertise, and decades of experience are the main capital sources for pre-IPO companies. They can guide the company’s management, help them with strategic decision-making, and help them through the process of transitioning from a private company into a publicly-traded company. The advice and insights offered by these investors can be invaluable, particularly for startups.

Not all start-ups are wildly successful. In reality, 90% of them fail. This underlines the importance of partnering with an investment manager who can identify the right companies.

Source: Investopedia. “How Many Startups Fail and Why?”

Hedge funds in 2021 have already broken the record for private investments in a single year.

A small group of hedge funds accounted for the vast majority of deals, with roughly three-quarters of the capital invested by 10 firms. The hedge funds entering this space include some of the most high-profile names in the industry. Some funds have launched dedicated businesses focused on private investments, with firms including Tiger Global Management, Coatue Management, and Altimeter Capital Management making big inroads into Silicon Valley in recent years. And some firms have also launched “crossover” funds that invest in private firms ahead of potential public listings and then hold on to their positions. Hedge fund firms have been able to access private assets because of their large base of institutional investors who are willing to lock up their money for longer if it means potentially earning higher returns.

“What has attracted hedge funds is predominantly a function of the opportunity set,” said Freddie Parker, co-head of Goldman’s prime brokerage insight and analytics team. A report from Goldman Sachs Prime Services highlights how hedge funds, typically known for investments in publicly traded assets, have been drawn to private markets to fire up largely lackluster returns. It also shows how private equity and venture capital have shot into mainstream finance. The asset class has soared to more than $7tn in value and is expected to double again by 2025, while the number of US public companies has roughly halved since 1996.

Source: Financial Times, September 2021. “Hedge funds muscle into Silicon Valley with private deals.”

Potential Advantages

• Purchase shares at lower valuations. When a company decides to file an IPO, the company can tap into public markets, which often drives up the valuation of the company due to the eradication of a liquidity premium. Getting in before the IPO allows investors to capture that up-swing in valuation. Once the company is public, previous investors can exit their position by selling into the public markets rather than through privately negotiated transactions.

Arbitraging Liquidity: Understanding the Liquidity Premium >

• Diversification. Pre-IPO investment valuations are private and are ‘marked-to-market’ whenever a liquidity event occurs. They are not subject to the same tick-by-tick change in valuations as public shares are. They are also less correlated to traditional assets, offering diversity to a well-balanced portfolio.
• Access a wider range of opportunities. Pre-IPOs simply offer additional choices. There are thousands of private companies that the public cannot typically invest in. Pre-IPOs allow investors to back a wider range of businesses than they would usually have access to.

Pre-IPO Risks

• Lower liquidity. You can’t freely sell your pre-IPO holdings on the public market, typically making it extremely difficult to exit your position, especially when the business isn’t performing well.
• Less regulatory scrutiny. Pre-IPO investments are not subject to the same SEC regulations and requirements as a publicly-traded company. This means they’re often less transparent than public-traded companies, making it more difficult to ascertain their true financial position and risk profile.
• No guaranteed exit. There’s no guarantee that pre-IPO companies will make it to the public markets. The process might be held up, delayed, or canceled. Without this public liquidity event, the upside potential is delayed and heavily limited.

Source: Hudson Point, March 2021. “5 Things To Look For When Investing In Pre-IPO Companies.”

Strategic allocations to private markets can enhance client portfolios. When done correctly, private market investing exposes client portfolios to a rich universe of high-quality investments that are not available in the public markets. Private equity allocations must be managed carefully, however, and should ensure that clients are diversified across both vintage years and strategies while paying particular attention to manager selection.