Why Winners Keep Winning in Private Markets | AWM Insights #90

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Episode Summary

To get the best returns in Private Markets you need to have an advantage. Do you have more information or uncommon expertise about the company? Can you add value to the company to improve their chances of success? Do you have the time and team to evaluate 1000s or deals a year.

The best firms keep winning for the same reason Alabama dominates College Football. The best talent, coaches & players,  want to go there. This success breeds more success. It is the same in venture capital.

Episode Highlights

• (0:28) News: Omicron and faster Fed tapering is causing volatility in the market.

• (1:26) Inflation has moved from being transitory to more persistent according to the Federal Reserve. .   

• (2:56) MLB Players have been locked out by MLB Team Owners. Until an agreement is reached, the MLB 2022 season is in jeopardy..

• (3:03) Money has been pouring in to Private Investments amid strong performance.

• (5:31) Private markets, unlike public markets, have information asymmetry which can cost novice investors a lot of money.

• (7:37) To get the best returns in Private Markets you need an advantage. You need to have better information or the ability to add value along with Capital.

• (9:51) About 60% of venture capital companies go belly up.

• (11:11) The winners keep winning when it comes to Venture Capital.

• (11:30) The best venture capital firms are like the elite College Football Teams. The best talent wants to go there and they get the best deals. It’s a self reinforcing cycle.

• (12:41) The best venture firms are seeing 1,000 pitches a year. They only pick a few.

• (13:37) Expected returns in the future - resetting your expectations

• (15:29) Private markets are not the most tax efficient asset class

• (17:25) Invest in the best in the private markets or just take your money and go right back to the public

Stay Connected

AWM Capital: IG | LinkedIn | Facebook | AWMCap.com
Justin Dyer: LinkedIn
Brandon Averill: LinkedIn

+ Read the Transcript

Brandon Averill (00:00):

Hey, everybody. Welcome back to AWM Insights. I'm Brandon and we've got Justin here and this is a podcast for our clients. We discuss the relevant topics in the public and private investment markets while also trying to tackle a broader investment lesson. And today's lesson that we're going to dig into is how to actually play the private markets like a pro, but before we do, let's turn it over to the market news and see what's going on in those private and public markets.

Justin Dyer (00:28):

A lot of news or a lot of jitters, I should say, there's obviously the Omicron COVID variant, which we touched on last week and a lot of digestion is still happening. There's a lot of unknowns with what it is or what it isn't. Are the current therapeutics going to work? Are the vaccines going to work, et cetera, et cetera. Some people are coming out and saying, "Hey, it's not that big of a deal." Other people are saying this could be another cause for concern. Hopefully, it's not a cause for concern like it was a year and a half ago and I don't think anyone necessarily thinks that, but it's interesting to see how the market digests new information. We always talk about that, that markets react and adopt or digest however you want to think about it, new relevant information, whether it's specific to a company or the broader market, and you're really seeing that take hold right now. The volatility has definitely increased over the last week or so.

Justin Dyer (01:26):

Not helping volatility matters, but the chairman of the fed, Jerome Powell, has significantly changed his tune on the inflation front. Something that we've also touched on time and time again, that there's kind of the belief from the fed, at least, that inflation was transitory, meaning it's going to come and go relatively quickly. Hasn't necessarily been the case, but they, as reacting to that, the fact that it's not necessarily transitory, have come out and really had a tougher tone, if you will, on their inflation battling language. And what that means is, I'm getting a little technical, but they'll probably stop buying bonds, which is part of their stimulus package. They're going to stop buying those bonds in the open marketplace sooner than they originally thought they would, or at least originally were telegraphing to the market.

Justin Dyer (02:23):

It is a big change kind of nuanced and a little wonkish there, but I think it was last Tuesday or Wednesday of last week, the language he was using was much, much different, almost he could argue a 180 from where he was prior. And then relevant to a lot of our listeners here and probably something everyone knows, but the MLB is locked out, not necessarily surprising, but unfortunate nonetheless. First shutdown since 1990 and hopefully, we get it resolved at some point soon.

Brandon Averill (02:56):

No doubt about that. Players got to get paid, you know?

Brandon Averill (03:01):

Hopefully, we don't miss any games.

Justin Dyer (03:03):

But today, the lesson we're going to talk about like you said is investors rushing into private markets and how we should think about that. What are considerations you want to take into account how we think about investing in the private markets? And it goes back to something I think we've talked about last week, not getting too caught up in chasing investing fads and having that fear of missing out. There are definitely good reasons to invest in private markets, but you need to be very, very thoughtful around it, so we're going to get into that.

Brandon Averill (03:38):

Yeah, I think it's great. And in that story that you referenced, there was a big article in the FT, the Financial Times talking about the investors rushing to these markets for returns. And I think, Justin, what we've seen is this is a little bit of that FOMO. I think people love the idea of big returns and we've seen some pretty big fund raises. A lot of capital has flown into this market. And I think it just exasperates the idea around really making sure that you're doing this in the best way possible and doing it like a pro because what it seemingly ends up happening or is ending up happening is that more and more people are being pitched with ideas because there is so much capital out there. And it's a little bit easier now, a lot of the venture capitals even talk about COVID and Zoom and all these webcasts now, they can actually see so many more pitches from companies on a regular basis.

Brandon Averill (04:40):

It's no longer having to devote a full hour to a coffee and driving there and driving home. And so, it's just a really interesting landscape, but the one thing that hasn't changed seemingly is this isn't the public markets, information is not efficient. I use the analogy a lot if we were going to sell AWM and I go and sell it to one of our clients and I give him or her all of our financial information, I open up the kimono, I give him all the information and then I turn around and I go to a competitor and I maybe just give him our client list. Those two people are going to come up with two pretty different values, I would think, on what AWM is. And now, that's perfectly legal in the private markets.

Brandon Averill (05:31):

And so, information is absolutely critical. Who gets the best information? Probably the person who is in the best position to be an advantage to the seller. And I think we can dig into that a little bit. I'd love to hear you explain why would I go to a certain investor over another if I'm raising money and I think it'll start to illuminate how hard this actually is. And some of those questions like, hey, if an investment deal was running across my desk or through the clubhouse, ask yourself the critical question, why is it here and why did all the pros pass on it, because the pros have certainly passed on it at that point.

Brandon Averill (06:17):

I guess I threw a lot at you there, Justin, but maybe tackle for us a little bit or start to explain why this landscape is so competitive and how do the pros actually go about allocating and why do the winners keep winning in this market?

Justin Dyer (06:36):

There's lot to unpack there, but it's a great topic. It's important to really understand what's going on here and let's start with the why, which I think you touched on a little bit, but there's an attraction. Why is there an attraction? Because there have been very good returns. Why should you make an allocation is kind of related, but is a separate distinct question where we, within our portfolio construction, think about the public markets and the private markets differently. Public markets, like we talk about, they're very efficient with the whole Omicron variant reflecting new information in a very efficient, fast way. The private markets don't exhibit the same behavior. There is that inside information so to speak, not from an illegal standpoint, but there is the inside track on information if you can get it, which is a very, very important distinction here.

Justin Dyer (07:37):

And so, when and if we are making an allocation to private market investments, we are doing so because we feel like there's an informational advantage and or there's also a value-add component to it. I think we've probably talked about this before, but asking yourself like you highlighted, Brandon, why are we getting this investment pitched at to us? Is it something that's been passed over or is there a unique value-add capability that we as a group, we as a net network have, whether that be because there's an interest in participating with athletes and founders or because there's an interest in our expertise and knowledge in running businesses and whatnot. That question around why along with the informational asymmetry, if you will, that's where we start to get confident in making investments in the private markets.

Justin Dyer (08:36):

The other thing I would say, which is an important consideration within private markets is yeah, the informational asymmetry exists and you can actually outperform and get alpha, as they call it in our industry, within the private markets, but there's also a different risk characteristic. There's concentration risk very much so in the private markets. You're investing in a fund or directly in a company, it's a single company. It's essentially like buying a single stock. Hopefully, you have some informational advantage and comfort in what they're doing, but there's a different risk profile there as well that's really important too to consider.

Justin Dyer (09:18):

Getting to your point around why do the winners keep winning, and that is something you see time and time again in the data within the private markets. You do not see that over on the public side of things. I want to underscore that as well. A mutual fund manager, an ETF manager that did well last year is not likely to be at the same point or position, if you will, in the performance lineup this year. There's just no persistence is what we call that in a good performer last year being in a good performer this year.

Justin Dyer (09:51):

That is not the case in the private markets, in venture capital, private equity. The winners keep winning and kind of, you alluded to it, it's because they have, and we've touched on this, it's because they have this value-add component. They have the network. They have the knowledge, the ability to help out a founder do what they need to do. And even all that being said, especially in the world of venture, it is incredibly risky and challenging. Something like 60% of early stage companies go belly up. Hopefully, I touched on all your points. I think I got most of them, but it is important to understand the differences in the nuances to venture investing or private investing in general. ntastic. And the analogy we've certainly given on this podcast before is relating it back to sports. It's kind of like college football playoff. You're going to continue to see the same teams often. Alabama's certainly there and Clemson's there and Georgia's there. There's a reason why these programs continue to show up. It's because if I'm a high school elite football player and I want to play in the NFL and I want to win a national championship, I'm probably looking to go to the place that's most likely to get me there.

Brandon Averill (11:11):

I might even accept a lower scholarship or a football, they're all full rides, but in theory, I'm more... We'll flip it to baseball. I'm probably going to take less of a scholarship to go to a Vanderbilt than I am to go to a school that's never played in the College World Series, because I know that I've got a much higher likelihood of playing for a national title. I've got a much higher likelihood of getting to the big leagues and it's the same in the venture market. If I'm going to build a cloud computing company, there are certain investors, certain venture funds and venture capitalist firms out there that I want to make sure my company raises money from. And I might even give them better terms than I would to just Joe Schmo investor, which ends up being a couple things. Certainly, that firm now gets the best look of those companies because of the reputation they've built, but now they're also probably getting the best terms, which inflates their returns on the back end as well.

Brandon Averill (12:16):

I think it's also how that process works. We've also talked about, again, the process for actually... I'm always fascinated by this and talking with professional venture capitalists, like how many pitches did you actually see and how many investments did you actually make and then kind of follow that up with, okay, great. You met with 1,000 companies last year. I mean, these aren't like-

Justin Dyer (12:44):

They're staggering numbers.

Brandon Averill (12:45):

Yeah. They actually met with them, heard their pitch and they end up investing in one or two. I mean, that's pretty incredible. And then you go, "Okay, well one or two, man. You must be really confident." They're like, "Well, we have 20 companies in the portfolio. We're hoping one or two return it." You think about the process there and then you think about how unfortunately, a lot of people, they're just so pulled in by the hope for returns that they hear one... I mean, I'm not immune to it. We hear awesome deals all the time and it's like, shoot, that sounds fantastic. And then you do the due diligence and you're like, "Ah, it's not going to work as a business," but I just think it's a fascinating process.

Justin Dyer (13:37):

Well, you touched on return expectations in the top tier firms, whether it be in private equity or venture, getting better terms, having a better expected return going forward. I also think it's important for this lesson that we're talking through here, this topic is to talk about just expected returns in general. There's something like $7 trillion in private markets right now. This company, Preqin, is estimating, it's a data aggregator, and they're estimating it's going to be something like over $7 trillion in assets under management over the next four years. Well, okay, that makes sense based on everything we've talked about, but not all that $7 trillion is going to make its way into top tier venture. And there's a bunch of factors to think about here.

Justin Dyer (14:26):

So, okay. You have more money following what might be a similar number of deals. You would only expect that rates of return or at least expected rates of return going forward are probably not going to be what they were in the past. You're having more dollars chasing same number of deals. Again, maybe there are more companies that are staying private and more entrepreneurs creating companies, but that's an aside for the sake of this conversation.

Justin Dyer (14:54):

We often, as individuals, think that the past is going to repeat itself in the future and chances are, it's not, especially with respect to this topic. Private markets probably will have lower rates of return. They should still be higher especially if you're in the top tier firms and whatnot, but it's only fair to reset your expectations that the past probably won't repeat itself especially because of so much money and so much capital out there. It is incredibly easy to raise money right now.

Justin Dyer (15:29):

And then another important component to this and we talked about this ad nauseam is the tax side of investing. You have one effective net worth and one effective tax rate. And unfortunately, venture is not, or private markets in general is not the most tax efficient asset class. It's not terrible because you're talking about long-term capital gains in most cases, but think about this compared to a, you go buy a diversified broad-based U.S. equity fund that you... an ETF or something like that. You can buy that. You can hold it.

Justin Dyer (16:08):

And we talk a lot about multi-generational wealth, chances are you're never going to need to sell that particular investment. You pass it on to the next generation. If everything stays as it is today, you get a step up in your basis and chances are you're never paying a single dollar in tax on that public market investment, versus in the private market side, you're almost forced to liquidate these companies, especially in venture where the company will either be acquired or go public or something like that or the fund itself will make the decisions for you. And you're forced to have a liquidation event and you have to pay taxes.

Justin Dyer (16:51):

Hopefully, you're in a top tier fund and the returns are what they should be and you've benefited from that, but you have a little bit more friction and it's something just to keep in mind. Again, it's taking that step back and thinking about your priorities, the long-term multi-generational wealth, the tax management side of investing is incredibly important, incredibly difficult, because it's over a longer term period of time and you don't see it at the bottom line of your rate of return, but it can erode rates of return over time.

Brandon Averill (17:25):

I think, it's a great point. I mean, we've tackled a pretty meaty topic today and I think we've thrown a lot at you guys, but I think just a good overview of the private markets, why we invest in them, why it makes sense for investors to invest with them, but also kind of a quick reminder of how difficult it is to actually achieve those returns that you want because that barbell or that distribution of returns is pretty dramatic. At the top decile, you're going to hopefully realize the returns and be compensated for that risk, that single company risk, the tax risk, the liquidity risk. You're going to be compensated for those things, but then when you really look at it, anything outside of that decile, I mean, the big takeaway is do invest in the best in the private markets or just take your money and go right back to the public because there's a quick drop off from that top decile in returns and you're much better off being in the public markets because you're just not compensated for the risk that you actually are taking.

Brandon Averill (18:37):

While we love them, you really have to evaluate are you in the right opportunities. And so, we'll dig into this topic some more over the coming year. We're going to break it down into more bite-sized pieces, but we thought we'd just have a broader conversation today. I hope you enjoyed it. As always, head over to awminsights.com. Drop us a line there. We'd love to hear what you guys want to hear about next. This is your podcast, so let us know. And until next time, own your wealth, make an impact, and always be a pro.