Fixing the access problem in private markets
Private markets are all the rage.
You know when something has risen to the zenith of the zeitgeist when The Economist gets hold of it, and that’s precisely what happened a few weeks back when that revered publication ran an article entitled, “Everyone now believes that private markets are better than public ones.”
Whilst we can’t say we agree with crude reductionism of the comparison, the article did capture the prevailing mood, characterising the fall of the traditional public-private market dichotomy and the burning desire of investors to capture returns from private assets:
“Institutional investors are rushing headlong into private markets, especially into venture capital, private equity and private debt. The signs are everywhere. A large and growing share of assets allocated by big pension funds, endowments and sovereign-wealth funds is going into private markets—for a panel of ten of the world’s largest funds examined by The Economist, the median share has reached 23%”
Another shocking factoid: from 2000-2018 the number of private equity-backed companies in the US rose from around 2,000 to around 8,000, whilst the number of publicly listed companies fell from 7,000 to more like 4,000. It’s now not uncommon to see Series A valuations of over $1 billion, and $3bn+ for Series C. We wrote about this almost a year ago now, but this is almost a decade-old story in the making.
There’s no denying this is a phenomenon heavily tilted towards technology companies that prefer to go further in private hands without having to contend with an increased regulatory burden, or answer awkward questions on quarterly earnings calls, but still. Private markets have arrived as a core feature of the investment landscape for investors and entrepreneurs, and they are here to stay.
The cause of this move can’t simply be attributed to low rates, excess liquidity in the system post Global Financial Crisis, or even once-in-a-generation tech unicorns pursuing disruptive new business models. It’s about how investors see markets.
A question of perspective.
Over numerous years working in emerging markets, we’ve learned that for a great many wealthy individuals and family offices, the public-private dialectic simply doesn’t exist. Perhaps it never did.
For some, investing isn’t about high degrees of specialisation and segregation – it’s about problem solving; looking at things holistically and deploying capital in a way that complements and/or diversifies the wider family business. A factory owner in Indonesia can be just as comfortable investing in a ride-sharing scale-up as they are in a plant machinery business. It’s all about timing and context.
At the same time, investors in the developing world are increasingly global in their outlook. Deal structures might still need to be tailored to fit local frameworks and conventions, but people are looking for the best opportunities they can get their hands on – not just stuff that’s close to hand.
The problem is, many developing markets are off the beaten track. Even the ultra-wealthy – people with literally billions to deploy – miss out on the merry-go-round of investment bankers and venture capitalists, who feel safer wining and dining more traditional sources of liquidity at Michelin-starred restaurants in London and New York (perhaps even Singapore if they can organise a wider regional roadshow and tack on a holiday at the end of it).
The A-word.
We have arrived at an impasse. Those seeking opportunities in private markets are all too often excluded from deal flow, and those seeking to access new pools of capital miss out because they don’t know where to start when it comes to navigating the unfamiliar streets of the developing world.
How does one boil all this down? It’s about access.
The rise of crowdfunding platforms sought to improve access to private deals, but that disruption has been superficial at best. Equity crowdfunding and P2P lending has become a retail proposition pushing small, early-stage deals. It remains close to impossible for high-net-worth individuals to access what we call “proper deals” – deals with heft, credibility and near-term upside opportunity.
Access is the critical thing when it comes to investing. It might even be the most important word in the investor’s lexicon, since without it, nothing can happen. As public market investors, we take access for granted. The established infrastructure allows us to enter and exit markets when we feel like it, at least, most of the time. Of course, there are (rapidly falling) transaction costs to be paid to facilitators of this privilege, but generally, we feel free to express ourselves and our views on markets on the public stage.
Not so with private markets. Investors looking to capture returns here face formidable obstacles. You can’t access non-public deal flow in anywhere near the same way as you can with listed equities. You can’t see deal flow in aggregate, and you can’t see the underlying financials of specific deals. Even if investors can access this information, they can’t get a seat at the table because it’s closed to anyone but the largest investors with the biggest networks and firepower.
Personal relationships and networks have always played a massive role when doing business in developing markets. This is particularly true when it comes to private assets. Global institutions don’t control access to capital in this space like they do in Equity Capital Markets – instead, it’s trusted local introducers and advisors, wearing many hats and juggling many balls. Here at Three Body Capital we believe the key to connecting capital with opportunity in the developing world is to champion these remarkable individuals and empower them with the right structures and incentives to do what they do best.
Information asymmetry.
Let’s say that you do know the right person, at the right time, and you get an early look at a deal. Even then, in that privileged position, it’s tough to access the documentation and data you need to make a qualified decision about investing. In public markets, investors have access to long-standing records, audit trails, market data and other information sources. But there is a fundamental informational asymmetry at play in private markets – the seller always knows more than the buyer. Much more.
This causes problems: information asymmetry was at the heart of “The Market for Lemons”, published in the 1970s by Nobel Economics Laureate George Akerlof (less well-known as the husband of former Fed chair Janet Yellen). Akerlof wrote about the market for used cars, where used car salesmen knew whether a car was good (“peach”) or bad (“lemon”), but the prospective buyer couldn’t tell. The challenge was not so much how these are differentiated, but what happens to pricing of peaches vs lemons, and how one possibility is that all used cars are priced and treated as lemons as a result, creating a gross mispricing of assets.
Research analysts in public markets used to add a tonne of value. They’d visit the CFO of a company, dig into the details to derive a critical insight, and write a report that would be sent to portfolio managers hungry for market moving information. Those days are over, and public markets are characterised by an even playing field that prevents CFOs from revealing anything meaningful to analysts that isn't already disclosed via publicly accessible investor relations channels. There is no informational asymmetry left for managers to tap into, so they must find their edge somewhere else.
It’s not so much that there are no more lemons left in the market. Rather, no one knows until one takes a nice chunky bite.
The upshot of this has been the rise of passive investing as a vehicle for capturing low-cost beta – investors aren’t stupid and they’ve realised that it’s irrational to pay excessive fees to fake “active” managers who do little more than track the index. They’d rather go private.
The edge lives.
In private markets, which are fundamentally opaque and illiquid, the edge prevails. This is a cause of excitement and exuberance (sometimes rational, sometimes not so much). We’ve seen a plethora of large institutions, endowments, Sovereign Wealth Funds, corporate treasures and the like fall in love with private markets, ever since David Swensen at Yale gave them his coveted stamp of approval way back in the 90s. There have been huge wins, huge losses, and everything in between. Many movies will be made about this period, and not all with happy endings. We must remember that, just like public equity markets, private markets are not good or bad in and of themselves. They are simply markets – to be studied, debated, pored over for the rest of history. You’ve got to love it!
The edge may prevail in private markets, but only for those with access to deal flow. Yes, big PE firms are going around acting like merchant banks, curating investments, committing capital as principal and syndicating to co-investees – but not everyone (actually, hardly anyone) moves in such lofty circles. Most investors in private markets have to rely on what they are shown by the aforementioned freelance brokers, introducers and advisors, who serve a hugely valuable role but cannot aggregate large numbers of deals due to operational constraints and the sheer complexity of manually juggling multiple transactions. Often, investors are not shown anything at all, because they don’t move in the right circles. The opportunity might well exist, but not to them, because they never get to hear about it.
A rallying cry.
These are huge problems, and we created 3BC to solve them.
Our deal platform connects professional investors with an eclectic array of private deals in emerging markets and beyond. By furnishing investors with access to comprehensive data rooms, we mitigate the informational asymmetry problem. In fact, we turn a huge disadvantage into a huge advantage, enabling investors to gain a greater, more nuanced understanding of markets in their totality via access to better quality information on privately held companies. We believe that focusing on improving investors’ access to information is a massive improvement on how the process works at present (it doesn’t work) and it’s a cornerstone of what we’re doing with 3BC.
In the spirit of peaches and lemons: we can’t tell you if you’ll like the peach, but we’ll certainly give you the means to work out if it’s a lemon before you bite into it!
At first glance, our platform might be seen as a threat to the traditional VC and banking model, since it disintermediates institutions by connecting investors to private deals directly. We don’t see it that way. Not all intermediation is bad, and VCs and bankers (the good ones) can play a valuable role in filtering and purifying private markets. They can aid the process of natural selection that perpetuates the strongest, most adaptive companies with the greatest chance of survival. This isn’t a zero-sum game and we actually see large and small institutions as important partners for what we’re doing with 3BC, since they have the ability to bring us deal flow and we can help them to drive incremental revenue.
But this essay isn’t intended to be a plug for our business. It’s intended to be a rallying cry for anyone who’s angry at being excluded from deal flow, who wants more visibility and a seat at the table. And it’s an invitation to entrepreneurs and advisors seeking to build new relationships with investors.
If this applies to you, please get in touch with us and we’ll set you up with a trial of our beta product. We would love to get your feedback and work with you to improve what we have.