The alternative asset class of non-listed companies. In recent years, it has been debated if the term „alternative asset class“ is to be considered outdated. This is an argument mostly brought forward by people involved in the private equity industry – which includes the VC industry – and is partly motivated by the fact that private equity has become mature and widespread enough to consider it in actual asset class. But the entire debate focuses on a lack of clarity on terms….
What is Private Equity. Private equity is a asset class where investors invest into equity, which is private. The first key difference to the stock market is that companies are „private“ in the sense that they do not trade publicly listed and hence do not confine to the regulation around publicly traded companies and the shareholder protection mechanisms. Since PE investors traditionally included only savvy and professional investors – ignoring the crowd funding market -, the regulation on protecting investors in private equity companies was and continues to be far less strict and protective to those owning share in private companies. And this definition is in fact the only relevant definition of „private equity“. With the rise of investment volume in this market, private equity certainly has become a mainstream investment area. Surprisingly, this feature does usually not have any impact when people are talking about private equity. You would classically talk about „alternative investments“ and would include art, collector items (stamps) at the same time. Whereas the defining feature of “alternative assets” is the lack of liquidity – ability to buy and sell in a short term with minor risks on the value of the investment – and a lack of both regulation and players actively covering entities or investment vehicles compared to the public markets.
Transaction-based investments. Another and more common feature that is used to define private equity as a unique asset class is the fact that most known private equity investments are done by companies and funds that buy and hold a security for a very short time horizon, before they sell the company with a profit. While this is not per se uncommon in public markets, too, there is a dedicated industry – which is classically called the private equity and venture industry – that exclusively focuses on buying for short to medium term profit. The investors in this arena invest via fund vehicles with a limited life span – typically 10 years – and they hence have to buy and sell companies in their portfolio within this time span. This time restriction is mostly uniquely found in the PE industry and hardly seen public markets, where funds typically are run as „evergreens“, without a defined end. Although infrastructure and non-publicly traded black label/special funds that imitate public funds also have limited life spans, too. There surely exists no venture capital company that buys for long holding periods for more than 50 years. And the funds that are typically called private equity funds also do not. If we call these funds transactional funds, we get another definition of private equity.
Highly leveraged transactions – VC vs PE. We now get to another feature that typically helps to seperate the terms „private equity“ and „venture capital“. Which is leverage. Private equity funds which are not venture capital funds typically buy companies with a very high level of debt as a means of financing the transaction. The company invested in by the private equity fund typically promises a stable return via stable revenues and operational expenses as to repay the debt within the desired time frame. Once you do neither have the stable revenues or the stable expenses, you do not have stable profits, which makes it hard to create a lot of debt to finance the transaction. So anything that neither stabilized revenues and expenses would not be financable by debt and hence called a venture capital investment, anything else a (transactional) private equity investment.
With all the definitions in place, what really defines the new ruling asset classes?
What really seperates the new ruling (transactional) private equity class from the public markets is networks. Publicly traded companies are performing well because of their networks in the industry and the investors typically are less connected to the relevant stakeholders that make or break a public company than the average investor. Only when an investor truly has a better network it will be able to generate value that is beyond the capability of the publicly traded value*. And in the context of venture capital, it is the most important feature of the investor that he is by far better connected to all stakeholders of relevance than the individual company executives and employees. It does not imply they know better. But they typically bring their network to support the company in a way which the company itself would not have replicated. [Although it could be a definition of a start entrepreneur that he has the better network than the investors he might seek.].
(* I am not saying all PE transactions occur because of this reason. The regulation issue and weak shareholders in public companies can also create sufficient opportunity to take a company private. The regulatory issue does play its own role.)
So networks could be a likely highly relevant feature of the current transactional PE industry. The life cycle of a network focused on bringing value on a particular nieche as it is found in PE and Venture Capital and the power over leverage this network for specific business purposes might be higher than the power of corporate executives to leverage their professional network as they transition between companies under stockholder pressure or to leverage their current company’s interior network as they are potentially restricted in going deep enough into the interior network to fully leverage is within their term of service.
The reason is simple: the transactional nature of the PE industry does not hinder the network from being effective when called upon. But structural heterogenity of several well-networked corporate executives playing under the same roof might suffer – more often than not – from incompatibility which makes the group of networked individuals less powerful. It renders the collective weaker than a constantly engaging collective of investors who play with and potentially against them.
Summarizing. The key idea is not that the networked private equity industry is rivaling the corporate world of publicly traded companies. But we are looking at a paradigm shift in this arena that focuses on stronger and longer-term oriented networks where people and their interplay is of higher importance than the mission of a corporate (ad-)venture. What is striking, nonetheless, is that the networked PE industries vet themselves using their networks, whereas publicly traded companies vet their executives using a less efficient system of Board of Directors where the latter are vetted by stockholders which are as a group likely the most heterogeneously networked decision makers, even if ownership is concentrated.
Opinions, as usual, my own. Appreciate opinion