The opportunity
We’ve all heard about the totemic success stories in business – the IT innovator who started a business in the garage that became a global tech phenomenon, and the digital entrepreneurs who conceived social media and ecommerce sites in their bedrooms that went onto be dot.com giants. Early investors build enormous wealth from these meteoric rises. Whilst they are the exceptions, many small and medium-sized companies that are privately owned by the founders or family and friends have the potential for growth and to build wealth for investors if they can secure the right level of funding and support. It is getting this at the right time and with the right support which can make the difference. With banks reluctant to lend, little media interest in small companies and no time for the entrepreneurs to get their message out to a wider audience, this can be difficult for these companies to achieve.
- Entry price vs public companies
So, this all means that investors who have the opportunity to invest in these small to mid-sized private companies face nothing like the “always on” global competition that defines listed stock markets. As a result, it’s often possible to buy private company shares at much lower prices than public companies.
Investors who have the opportunity to invest in these small to mid-sized private companies face nothing like the “always on” global competition that defines listed stock markets.
- Management equity and passion
Private companies are typically managed by people with a big stake in their success. Where the average listed company chief executive owns less than 3% of the business he or she runs, private company CEOs are more likely to own around 10-20%. But the motivation is not just financial. Private company managers are often fulfilling their dreams, taking a once-in-a-lifetime chance to make their mark on the world. The enormous dedication and drive of such managers can bring great benefits for their investors. Often the “tipping point” that is most likely to propel them to new levels is an injection of funds combined with investment growth expertise.
- Tax benefits
As well as the value that can be gained by investing in small and mid-sized privately-owned companies, there are also a range of powerful tax reliefs to support investors. Shares in unquoted companies benefit from Business Relief after they have been held for two years, meaning that they fall out of an investor’s estate for Inheritance Tax (IHT) purposes. The Enterprise Investment Scheme offers generous tax reliefs for early-stage companies and Investors’ Relief offers reduced rate of Capital Gains Tax (CGT) for more established small and medium-sized private companies. Loss Relief is also available for any equity investment in an unquoted company and losses on private company lending can be offset against interest income.
Why private companies should be part of a balanced portfolio strategy
No doubt you’re aware of the risk of over-exposure to any one asset class, but making sure you diversify your portfolio can be something you put off or are unsure how to go about. Private company investing adds a different source of wealth creation because returns are not closely correlated to traditional asset classes, such as listed shares, gilts and corporate bonds. Studies also suggest that the long-term returns of private equity exceed those for public equities. Investing in private companies offers diversity, but has been difficult in the past for investors to access.
Barriers to entry and the alternative way to invest
Traditionally, there have been significant barriers to investment in private companies because the time required to find the companies, and then to undertake research and due diligence has mostly been prohibitive. The alternative route available was to invest via a private equity fund which offered investors no control over and little information about where money was being invested. More recently, it has become easier to invest via crowdfunding platforms, but the companies on these platforms are mostly early stage and have been the subject of little due diligence, thereby presenting a greater degree of risk.
In recent years, direct investment into more established companies with the support of a professional investment company undertaking the due diligence has become a real alternative.
In recent years, direct investment into more established companies with the support of a professional investment company undertaking the due diligence has become a real alternative.
An approach to asset allocation
We would never recommend that “following the herd” is a good reason to invest, however there is no doubting the popularity of private company investing among the very wealthy. With better accessibility and awareness of the sector, there is growing trend for very wealthy individuals and family offices to allocate ever-higher proportions of their wealth to private equity.
There is no magic formula that provides the right ratio, or amount of private company investments to include in your portfolio – it is much more important that investors address the idea of creating a balanced portfolio by selecting a range of different assets classes and different risk-profiles. We would always encourage investors to discuss the asset allocation of their portfolio with their wealth manager to ensure they are putting an appropriate proportion of their wealth into both traditional and alternative investments before making any big investment decisions.
What are the risks and ways to mitigate these?
You won’t be surprised to hear that mitigating risk is about creating a diverse portfolio of private companies and not trying to pick the one star performer. For this, you need access to a flow of investment opportunities. Using a professional company, which undertakes due diligence on the business and the management, and which looks to negotiate good terms for investors is a good place to start.
Private company investment offers investors a choice of equity or lending. By building a portfolio across both the lending and equity element of a company’s funding requirement, investors can control the level of risk that they are exposed to, whilst still generating a good level of return.
By building a portfolio across both the lending and equity element of a company’s funding requirement, investors can control the level of risk that they are exposed to, whilst still generating a good level of return.
There are of course some drawbacks to investing in private companies. It’s rarely possible for an investor to sell at the time of their choosing. Instead, investments are realised by an “exit” arranged by the company or the manager acting for all investors. This tends to increase the price achieved by selling investors, but means waiting for the right time.
Working with providers such as Rockpool, which finds companies past the start-up risky phase, but not yet large enough to attract traditional private equity funds, is a route that can offer investors great value. We seek out profitable private companies run by management teams who have expert knowledge, impressive industry experience and a real passion for their business. Rockpool doesn’t interfere in the day-to-day running of the businesses, but is there to support the management teams of these firms if they need it, to continue to look out for the interests of investors and then guide the company to exit.
Your next steps
Private company investing can really help power up your portfolio, diversifying your risk exposures and delivering returns uncorrelated to those of traditional asset classes. However, the special characteristics of private company investing means that taking professional wealth management advice is essential for most investors. If you would like to discuss where private company investing might benefit your financial strategy, and how wealth managers work with providers such as Rockpool, please get in touch with findaWEALTHMANAGER.com’s expert team.
