What are the risks and rewards associated with investing in the private market?

Introduction

Investing in private companies can be an attractive option for investors looking to diversify their portfolios and tap into high-growth opportunities not available in the public markets. However, private investments also come with unique risks that must be carefully evaluated.  

In this blog, we'll break down the key risks, potential rewards, and how to mitigate the risks of investing in the private market.

Overview of Investing in Private Companies

The private market refers to investments made directly into private companies that are not publicly listed on a stock exchange. Private companies may be startups in the early stages of development or more mature businesses looking for private capital to fund growth. As an investor, you can gain exposure to private companies through platforms that pool investor capital or by investing directly in a company.  

Compared to investing in public stocks, private market investments can be more complex and hands-on. You may need to conduct significant due diligence, negotiate investment terms, and actively monitor your investment.  

However, the private market also provides opportunities not available to typical stock investors, making it a potentially lucrative yet higher-risk segment of the broader investment universe.

Understanding the unique risks and rewards of the asset class is key to determining if private market investments have a place in your portfolio.

Risks Associated with Investing in Private Companies

While private investments can offer outsized returns, they also come with increased risks that you must be prepared to take on. The 6 key risks include:

1. Lack of SEC oversight- Private companies are not subject to SEC regulations and reporting requirements, which can lead to opacity and potential misconduct.

2. Liquidity risk - Private investments are highly illiquid, meaning there are limited opportunities to sell your shares should you need to exit an investment. You may have to hold onto a private investment for 5-10 years or longer.  

3. Lack of oversight or Limited Information - Private companies do not face the same reporting and disclosure requirements as public companies, leading to less transparency.

4. Market risk - Private company valuations can fluctuate significantly based on market and economic conditions. Investors have limited insight into the true value of a private investment.

5. Stage of company growth - Early-stage startups often require more time to mature and reach profitability, increasing the risk of failure.

6. Valuation challenges - Private companies are not subject to the same reporting requirements as public companies, making it difficult to evaluate their true value.

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Rewards Associated with Investing in Private Companies

While higher-risk, the private markets also offer opportunities for significant upside through equity-like returns. Some of the key rewards include:

1. Exposure to high growth and returns -Private companies are often positioned for rapid growth, providing opportunities for substantial returns. Investors can profit from the value creation typically reserved for private investors. ‍
2. Active involvement - With private investments, investors often play an active role advising the management team to help drive growth and profitability. This hands-on involvement can enhance returns. ‍
3. Diversification - Private investments add diversification to a portfolio concentrated in public equities and fixed income. The private market offers returns that tend to be less correlated to public stocks and bonds. ‍
4. Access to innovation - Private investors get early access to disruptive technologies before they go mainstream, something typically only available to venture capitalists and private equity investors.

Tips for Mitigating Risks When Investing in Private Companies

When investing in private companies, it is crucial to take steps to minimize risk exposure. Here are some tips:

1. Only invest what you can afford to lose - Allocate only those funds you could afford to lose completely to private deals. Keep speculation to a minimum.
2. Diversify across multiple private investments -Build a portfolio of private company investments across different sectors, stages, and geographies. Diversification reduces overall volatility.
3. Conduct in-depth due diligence - Vet the management team, product, market dynamics, financials, valuation, and investor rights before investing. Information may be limited.
4. Negotiate strong investor rights - Push for rights like board seats, voting, liquidation preferences, and pro rata that can protect you. ‍
5. Be ready to hold long-term - Prepare to remain invested for 5-10 years or more, given the illiquidity. Avoid the need to exit quickly. ‍
6. Invest through an experienced fund - For those new to the asset class, investing via a professional private equity or venture fund can reduce risk.

Conclusion

Investing in private companies can be both rewarding and risky. While there are potential benefits, such as higher returns and diversification, investors should be aware of the risks involved. By taking a prudent approach, private market investments can enhance portfolio returns and diversification.  

By understanding the risks and rewards and following the tips for mitigating risks, investors can make informed decisions about whether to invest in private companies as part of their diversified portfolio.