Investors urged to consider mid-size private companies

In hindsight, everybody would have invested in Apple back when it was a smaller, obscure private company. But as its founder Steve Jobs famously once said in a different context: “You can’t connect the dots looking forward; you can only connect them looking backwards.”

So for investors who can stomach the risk, private companies valued under US$1 billion can offer great returns, particularly at a time when they’re waiting longer to list themselves on stock exchanges. The reason for the longer wait is that in recent years, companies have been able to raise more money on the private markets, says Federico Schiffrin, investment director of private equity at Unigestion.

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For example, Facebook’s valuation before going public about four years ago was US$75 billion. “That would have been unheard of 10 years ago. There wouldn’t have been enough private money that would allow the company to get to a $75-billion valuation,” says Schiffrin.

Take U.S. technology firms. A recent Unigestion paper noted that between 1995 and 2005, they waited on average six years before going public. The number increased to seven years between 2005 and 2009 and 10 years between 2010 and 2015.

It’s a trend that’s good for the businesses themselves because going public requires them to subject their performance to greater scrutiny, says Geoffrey Ritchie, vice-chairman of the Private Capital Markets Association of Canada. “Most of that isn’t compatible with a company that’s in a fundamental growth phase where it’s making key strategic decisions and it’s trying to scale up.”

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And, going public is virtually irreversible, Ritchie adds. “It’s a bit like Hotel California. Once you’re in as a public company, there’s no real way out aside from a very complicated transaction.”

Basic questions for finding deals

  • Does the company need to fix its balance sheet?
  • Do its products or services have long-term potential?
  • Who is running the company?

For investors, that means by the time the firms go public, private equity buyers have already extracted much of their investment profit potential in the private markets, says Schiffrin.

Greater returns

The smaller end of the private equity universe — which, according to Unigestion, currently has about 500,000 investable companies worldwide — promises higher returns than larger private companies. Within the span of a decade or two, a basket of investments in small- and mid-size private companies can produce returns that are up to 500 basis points higher than those from the larger end of the private equity market, according to Unigestion.

That’s mainly due to inappropriate pricing. Because small- and mid-size private companies are obscure, they’re usually priced less efficiently than larger ones, says Schiffrin.

“Getting to know these companies is by definition a lot more difficult than it is with the large ones.” As a result, investors can buy into a promising small company at a lower price, he notes.

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Smaller firms often require more improvement than their larger, more established counterparts. While smaller businesses have features that have made them somewhat successful, they often lack something crucial, such as a strong management team, diverse product lines or wide distribution networks. Making those improvements can add tremendous value, says Schiffrin.

A lot of bad apples

A big risk in the smaller end of the private market is that the difference between the best and the worst companies is greater than in the larger end. For example, in the United States, the variance in returns between a top- and bottom-quartile performer is 17% in the small- and mid-sized market. That compares to 7% in the large private market, according to Unigestion.

That’s why investors need to be selective. Schiffrin says out of every 120 firms his team looks at, it picks three or four. It still makes mistakes. Once, it failed to accurately assess a German company’s
management team. “They weren’t as good in execution as we thought they were,” he says. “You hope you get right 60% or 70% of your companies. But you don’t want to lose money on the other 30%.”

Costs can be high

Because they have the size and resources, some pension funds occasionally invest in smaller companies directly instead of going through funds run by asset management firms. The private equity fee structure usually includes a management fee of 1.5% or 2% of committed capital plus 20% of profits after a hurdle rate of about 8%, says Bradley Morrow, head of research, Americas, at Willis Towers Watson.

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“But then you have the cost associated with having a large staff that has the resources to find those deals,” Morrow adds, suggesting that’s why many institutional investors prefer to use funds.

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Yaldaz Sadakova is associate editor of Benefits Canada.