The Basics of Private Market Investing | AWM Insights #149
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Episode Summary
Private Markets come with a very different set of challenges and rewards when compared to Public Markets.
Unlike the Public Markets, there are requirements that need to be met for investors to be able to access Private vehicles as they are illiquid. Private Markets are also much less transparent than their public counterparts and, for that reason, require significantly more due diligence.
There is a large dispersion of returns between Private Market funds due to expertise and manager’s skill, which is not true of Public Markets. Access to these best-in-class managers is very competitive and cannot always be obtained with “just a check”.
All these dynamics make it extremely important to work with a trusted and experienced advisor when thinking about allocating to the Private Markets.
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Episode Highlights:
0:00 Intro
1:40 What are Private Markets
3:04 How Venture Capital and Private Equity fit into Private Markets
4:50 Differences between Public and Private Markets
7:54 Who can invest in Private Markets
9:03 Money alone isn’t enough to get access to the best funds
10:50 The logic behind limiting participants and access in Private Markets
12:06 Why vintage diversification is so important
13:24 Why would you want to participate in Private Markets?
14:00 Text us
+ Read the Transcript
Brandon Averill (00:03): All right, we're back. And for those of you that don't know, and most of you won't know, this is one of our last podcasts from this office, at least. We're making the trek back to the old stomp ground in Pasadena. So you're going to see a new background here coming soon. We may have one more in us here, but it's good to, I guess wrap it up here. And no better place to [inaudible 00:00:25] ... yeah, to wrap it up than the private markets. I think we've seen, Justin, over the past couple weeks, just the private markets have been in the news a lot. We've had Silicon Valley Bank, that Silicon Valley is really, I think what most people's heads go to when they start to think about private markets in the company ownership space. Obviously there's private markets with real estate, and that world is huge, and I think you can think about it in different ways.
(00:54): But as we enter this year and with clients, obviously paychecks are starting to come in for baseball players, we're setting annual plans for other clients of other sports or our founder clients, we're starting to think about what the private market allocation looks like for this year. So thought it'd be fun for us to just walk through, again, some basic fundamentals. What are the private markets? Maybe a definition of that. Why do we participate in the first place? And then ultimately, how do we know it's time for a client to actually participate in the private markets? Because there's lots of advantages to it, but there's also some things that make it a little bit more difficult for some people. So let's just jump from the top. Pretty simple question, but what are the private markets? When we talk about the private markets, how would you define that?
Justin Dyer (01:45): Sure. So I'll start really, really broad. There's private equity markets or ownership in companies. There's public equity markets, which hopefully everyone's familiar with. There's private debt markets. There's public debt markets as well. Private real estate markets and public real estate markets. You can go down the list. But real broadly speaking, private markets represent a wide swath of investments that don't have to go through certain reporting requirements. They don't trade on formal exchanges, like the New York Stock Exchange or the NASDAQ. And typically they range in size. I mean, you can have your mom and pop carwash or dry cleaner down the street all the way up to some of the world's largest companies being private. So they span a really, really wide range, both of type, equity, debt, real estate, et cetera, but then also size really across the board. Whereas in the public markets, you do have a range of size and type, but it's a little bit more concentrated on the larger side of the spectrum.
(02:56): So I think real, real high level that is private markets maybe getting into certain stages or types of private market investing. You did allude to Silicon Valley. That's certainly the epicenter of venture capital. And venture capital is where venture capitalists, or investors as they're called, are taking a venture or they're really taking risk in starting new companies. In some cases they're starting completely new marketplaces. And then you go into traditional private equity, which is really, these are already proven quantities, these companies in the private equity space. And then debt similarly is generally in the private, traditional private equity space. So I'll stop there and keep it high level.
Brandon Averill (03:43): No, I think that's great. And we often talk about some stats, and these are rough stats, but when you look at all the companies in the United States, I think it's something like only 2% of them are actually publicly traded.
Justin Dyer (03:56): I think it's global, yeah.
Brandon Averill (03:57): Or globally. So 98% of companies are actually in this private market space. And I think if we hone in just on actual private companies, that would be good for today and we can do real estate another day, or debt, et cetera. But just thinking about that, so we've got this body of companies that we could potentially invest in. And I think what you hit on there is there are some benefits, obviously there's some downsides. And it really, as we start to unpack the different layers of what those private markets hold, what we start to unpack what that looks like, and just by reference what the public markets, that 2% that actually is traded, what you get with that is you get really a lot of transparency. You get a ton of information.
(04:49): It's why we believe when we build your guys' portfolios and we build that stock side, when we're doing it in the public markets, we don't think we're more clever than somebody else. We have access to some information better than somebody else. And so it's because that information is out there and available to everybody. The other big part of it is liquidity. If I'm sitting here today and I want to go make a purchase, I can look at my stock portfolio, and it might not be the right time, but I could sell that and turn it into cash and go do what I want with it. I'd love for you to hit on a little bit what starts to happen when we go to the private markets. I think obviously-
Justin Dyer (05:31): It all changes. Yeah.
Brandon Averill (05:32): ... you can't go just cash a check. And maybe talk a little bit about that. And then on the heels of that, we can maybe dig into because of some of these factors, when does this come into play for [inaudible 00:05:44]-
Justin Dyer (05:44): Yeah. So touching on the information side, the coin is completely flipped in the private markets. There aren't a set of rules. You can't defraud anybody. So in a sense, there are some basic rules that have to exist in the private markets. But versus the public markets, I mean it's, let's call it the wild wild west, if you will, for an extreme kind of visual example where you've used this in this example in the past, we own a privately held business, small business. If we were to go to sell that, we could give different investors different information. There's not a bare minimum amount. Again, we couldn't lie to them, but we could give people different amounts of information. In the public markets, you can't do that. If you do that and someone acts on it, becomes insider trading, which is a term probably familiar and you want to avoid that.
(06:35): But then to the point around liquidity, these markets, the private market is large, but there isn't this place you get to go to each and every day to trade. That's the typical visual of a market. There isn't a marketplace for the private markets, even though we're calling it the private markets. Now, it doesn't mean you can't actually liquidate your investments, but it's just a lot harder. You have to go search out a buyer. Maybe you have to hire a middleman or a broker to find a buyer. Maybe you're an investor in a fund and you don't even get to decide when an actual underlying investment is liquidated. Or if that's the case, you can go to a secondary market buyer that might buy your interest in a fund. And I'll stop there because I don't want to go too far down this rabbit hole.
(07:21): But suffice it to say there's just a lot more nuance, there's a lot more difficulty, there's a lot more challenge. But with that challenge, that's actually one of the reasons why you expect a higher return. It's called an illiquidity premium. You can't just turn your money around right when you need it in a very easy way. And it also costs more money to do so when it's time to go do that. And that illiquidity premium's one example or one reason why you have a higher expected return in the private markets, and it's proven itself over time, but there are many others.
Brandon Averill (07:53): And I think that's why good time to turn to, that's why the government does come in and set some different guidelines to who can actually participate in these private markets. And so, one first step is something called the accredited investor. So they actually say that you have to have a million dollar net worth or make what, 2 or 300 grand-
Justin Dyer (08:13): 250.
Brandon Averill (08:14): ... over two out of the last three years. And that's a base level that they say, ah, you get to come in and you get to participate in this market. We often analogize it to, well, I guess anybody that knows anything about the golf world. There are country clubs out there. If you have a certain amount of money, you probably can go join a country club. And then there's probably some social aspect to that where you go through an application process, somebody has to vet you, and then if you can write the check and they say, hey, yeah, we want you in, then you can join the country club. And I think that's the accredited investor.
(08:52): You meet these criteria, then you go find the right private company. They say, yeah, we want you to invest in this company and we'll take that investment and invite you in. But for those of us that are golf fans or you know things, there are different levels of country clubs. There's also this little place called Augusta National that we're going to see a pretty big tournament in the next couple weeks. You could have all the money in the world, you show up-
Justin Dyer (09:20): You're not getting in.
Brandon Averill (09:20): You're not getting in. Augusta, the membership community, you got to have the social sway. There's the same thing in this world of the private markets. The next step-up is what we call qualified purchaser, and the government actually says, okay, this is 5 million of investible assets or more to qualify as a qualified purchaser. And the reality is, if you spend time in specifically the venture capital world, et cetera, the best companies want qualified purchasers.
Justin Dyer (09:51): Typically, yeah.
Brandon Averill (09:52): It's typically how it works. And so this is that next level. And then we certainly could delve into a future podcast on the social aspect, and getting access to the right funds and all that type of stuff. But for today's purposes, really for clients that are listening, there may be some of you guys that aren't quite there yet. We've brought you on clients because we have a very convicted belief that you're going to have a net worth of $30 million or investible assets of $30 million or more in the future, but we're still building towards that and we haven't opened this up yet. On the flip side, for those of you listening that are participating, you know you meet these qualifications, we're able to give access to this. And we're pretty careful and systematic about it, because you need to be in a financial position to be here for the long haul. So maybe even talk a little bit about the systematic nature of how we look at things and why this is so important?
Justin Dyer (10:48): Yeah. And I'd even just hit on too, there's a rationale. We're not going to necessarily pass judgment on whether the criteria that's out there is correct or not. I mean, there's plenty of debate going on within the world of private market legal opinion at the moment. But the logic is that you need to be sophisticated to play in these markets because these markets are more risky. To your point, there's more opportunity there, but there's also a lot more junk, if you will. And so by putting this criteria in place, it's an assumption, or at least a measurement, proxy measurement of sophistication. We, to your point, take it even further step forward and think a lot about access and whatnot. And obviously we do this on a daily basis and can get a lot more comfortable than the average person, even if they are of high net worth.
(11:38): But taking a step further beyond access as well is thinking about it in a systematized process. We know diversification is a great benefit. We've talked about that a ton, especially in light of what's going on in the market, both public and private markets right now with SVB or just the volatility in the public markets, diversification is always your friend. You can rely on that regardless of what your investment strategy is, and you should rely on that across the board. And again, private market's no different. So we like to see participation over what's called multiple vintages. The way in which private market funds typically work, you have a vintage. So this year it's going to be 2023 vintage funds that are really created in raising capital and starting to deploy capital. And all those funds get lumped together when they get compared to each other.
(12:29): We know that there are going to be good vintages and bad vintages. There are cycles in the private markets just like there's cycles in the public markets. But if we can build a plan and approach for you guys within our portfolio construction that assumes we're going to at least participate in five vintages, we get really comfortable with that because we're getting time diversification. But then we're also keep in mind getting diversification across funds. We're getting diversification across companies. And the hope there, the assumption, the model is that that gives us confidence that we will see the higher expected return from the private markets. We should see the higher expected return from the private markets over that long period of time to give you the result that you deserve.
Brandon Averill (13:13): And I think that's a great place to wrap up, because I was going to bring it around to this is for clients, you're listening to this, I'm sure you're like, holy cow, why in the heck would we even participate? There are all these loopholes, there's this complexity. I'm tying up my money. And you hit the short punchline to that is higher expected returns. And if we're dealing with multi-generational timeframes and investment decisions like we are for most of you guys, we want our money that we're not going to use in our lifetime to be allocated to the highest expected returns. And so when we work through your priorities and we lay out, hey, this is what it's going to take to support the life that you envision, then we have assets in excess of that very simply. We want those to have the highest expected returns humanly possible.
(14:02): And that's where these investments lie. And so why we take the time and the effort, and we spend so much time in Silicon Valley and participating in the venture markets specifically so that we can participate for our clients in these areas of the market. So we'll wrap up for today. A lot more to unpack, and we can unpack this in future episodes if you guys find it interesting. As you know, can text us. That number is (602) 704-5574 with any questions you have and we'd love to address them in the future. And until next time, own your wealth, make an impact, and always be a pro.