How many times have you heard someone say, "Don't put all your eggs in one basket"?
When it comes to any kind of investing, this is very good advice.
But, if this is the case, why don’t private equity investors diversify?
Unfortunately, most individual investors in private equity significantly under-diversify their portfolios -- investing in one or only a handful of companies. By so doing, they both greatly increase their risk profile and greatly decrease their probabilities of seeing investment return.
Quite simply, investing in just one or a handful of private companies is way, way too risky for most investors and should be avoided at all costs.
Rather, to leverage the dynamic returns in this sector - 20-year average returns of over 20.6% (Thomson Financial/DowJones) - the only prudent approach is via a portfolio of positions. If done appropriately, this strategy is by far the best approach to leveraging the vast return potential of private equity without the principal risk normally endemic to this investment class.
How To Build a Portfolio - Problems With Current Solutions
Admittedly, a portfolio approach to private equity is much easier said than done for the individual investor. The 3 traditional methods of so doing have drawbacks:
- Build a Portfolio One Company At A Time. It is certainly possible to build a portfolio one company at a time. Famed technology investors like Vinod Khosla and Ron Conway have taken this approach, with personal investment positions in literally dozens (if not more) of companies. They, however, are both professional investors and techologists, and deeply networked into the core U.S. angel investor deal community - namely Silicon Valley. And as they and other both admit in interviews, there are strong "hobbyist" and "philanthropic" aspects to their deal interests. Vinod Khosla, in particular, has stated that he is motivated in his current investing as much by his desire to contribute to the development of eco-friendly technologies as he is to making money.
- Join an Angel Group. Increasingly in recent years, there have sprung up angel investor networking groups around the country. Most are centered in the main entrepreneurial hubs - Silicon Valley, Los Angeles, Boston, New York, Austin, Phoenix, Salt Lake - among other locales, and generally involve groups of individual investors coming together to review and diligence deals in a group review format. These groups have a lot of benefits - including networking and providing a forum for both less sophisticated investors and entrepreneurs to learn the basic process of private company investing. Like Mr. Conway and Mr. Khosla, many of the angels in these groups are retired (or semi-retired) executives and businesspeople who participate in them as much from a hobbyist perspective as from a money-making one. Not surprisingly, their general investment track records are mediocre at best, and there is a high likelihoof of "negative selection bias," whereby the better companies and entrepreneurs are often loathe to approach them because of the inefficiencies of their investment processes and the somewhat "off" messaging and perspectives of many of their members.
- Become a Limited Partner Investor in a Venture Capital or Private Equity Fund. While the biggest private equity and VC funds - the Blackstones and the Sequoias of the world - are, because of their size, off limits to all but the largest of individual investors ($50 million+), there are literally thousands of smaller venture capital and private equity funds that accept capital in smaller increments from individual investors. Some of them have good track records of success (though relatively few in the current market), but as "portfolio plays" they have some core limitations:
- All but the largest funds themselves only invest in a handful of deals. It is unusual for the typical VC or private equity fund to do more than a few deals/year, and also have a tendency to concentrate their holdings in a single industry or stage of business.
- Far more problematically, because of their traditional 2.5% (on average) management fee model, there has been a great propensity in recent years for the better funds to grow quite large. It is unusual for a fund with quality managers with a track record of success to have less than $150 million under management. This larger fund size, in turn, greatly defines the kinds of deals in which the fund can, for logistical purposes, invest. It is unusual for a fund of this size to make an investment of less than $10 million into a single deal, thereby requiring them to invest mainly in later-stage technology and/or higher cash flowing middle market companies. While there is nothing inherently wrong with these strategies, the problem is that in recent years there are have been literally more venture capital and private equity funds out there than actual operating companies in which to invest! This reality has a) greatly driven down the number of deals that a typical fund has/can do in a particular year and is b) leading to a "dead man walking" fund phenomenon where funds sometimes go years without actually making investments.
So What To Do?
At Growthink, we are extremely passionate advocates for private equity investing - both because of its uniquely powerful return potential and because of the incredible social value of providing capital to fuel the entrepreneurial engine of both the American society and the global economy. We strongly recommend, however, that anyone evaluating earlier-stage, private company deal opportunities do so only in the context of significant advisory and diligence assistance from accounting, legal, investment banking, IT services, and management consulting firms that specialize in working with startups, emerging companies, and small and medium-sized enterprises. And while it is obvious to almost all that the big Wall Street banks know nothing about this sector (and in light of their recent travails, whether they know anything about anything at all related to investing), what is less obvious is how little - in their current construct - that private equity and venture capital firms both know and care about the space.
Quite simply, as a wise old horseman once quipped - bet on the jockeys not the horses. And the jockeys in this brave new world of ours are those that every day advise and support the future superstar operating companies of the next private equity bull market.