Angel Investing: Perspectives of a Stock Market Operator

I have been involved in the stock market on a professional basis for over 20 years, but in recent years my attention has additionally been drawn to private companies. In total I have made around 12 private investments — across various industries, but with a focus on financial technology.

My transition from public to private investor is not unique. Blackrock recently published its annual survey of global asset allocators, collectively responsible for over US$7tr of assets, and many of them are doing the same. Just under half of those surveyed plan to increase their exposure to private equity this year, funding it largely via a reallocation from public equities. For individual investors the growth of angel networks and crowdfunding platforms has opened up access to private investment opportunities that otherwise would not have been apparent.

A lot has been written about the implications of this development, which include companies staying private for longer and fewer companies being listed on national stock markets. Rather than discuss the implications, this article looks at the differences and the similarities I have experienced between public and private market investing. Four key differences stand out.

First, transparency.

Stephen Schwarzman is the Chairman and CEO of Blackstone, a firm he founded in 1985. He started his career as a public market security analyst but early on he shifted his focus towards private investing. In typically entertaining fashion he tells the story of why he made the switch. The summary is that as a young analyst he approached a company executive with a list of questions and was frustrated that the executive would not answer them because the information was not public.

“I said, well if he didn’t answer, how in the world can you figure out what to do? I said, I’m not that smart; I need to have all relevant data and he’s the person who has it, so why won’t he give it to me?…

“What I’ve sort of done for a career is try and solve that problem of my initial meeting, where people will — I want people to tell me what’s really going on, so I can figure out whether what they’re saying makes sense or doesn’t make sense. You can do that in the private equity business…”

Now Steve’s concern doesn’t overcome the fact that there are a lot of unknowns out there in both private markets and public, and the amount of information available doesn’t change that, at least above a certain threshold. But the ability to see monthly financial data, to get feedback on customer conversations, to be able to probe management on what’s going on is a fundamental difference between private and public market investing that impacts the ways the respective games are played.

Second, volatility.

In December the stock market was down 9%. At one point (Christmas Eve) it was down as much as 15% on the month. The year-end valuation statements I received duly marked down my public equities portfolio accordingly; yet my private investment valuations remained unmoved. That was because there is no continuous market in private investments and so their valuation simply reflected their most recent marks. In some cases valuations can be updated to reflect fundamentals of the underlying operating business, but as fundamentals don’t change so much over a three-week period in December, that didn’t happen. Dan Rasmussen of Verdad Advisers is critical of these ‘smoothing effects’. In an article in American Affairs magazine he quoted the CIO of the Public Employee Retirement System of Idaho who called this the “phony happiness” of private equity.

Over the long-term valuations will catch up with companies whether they are private or public. A private company may go to zero (indeed is more likely to than a public company) it’s just that the path down there won’t be as smooth as a Sears, say, which means that acceptance may be delayed. Conversely, a private company may end up as a ten-bagger but the inevitable trials and tribulations it suffered along the way may not have been reflected in its refreshed valuations. That’s unlike Amazon, for example, whose listed stock is up over 30x since the beginning of 2009 but whose shareholders had to suffer five episodes of 20%+ collapses in valuation over that time.

Just as the ups-and-downs of valuations can overstate the underlying business dynamics of public companies, their suppression in private companies can understate what’s going on there.

Third, structure.

A public market investor doesn’t really have to pay much attention to the security he buys. Most public companies, although not all, have a single type of common equity that trades on the local exchange. The question of investing distils down to what company, and how much. That’s not the case in credit, which is all about structure. Nor is it the case in private market equity.

The most famous example of how structure can affect the outcome of a private investment was featured in the film Social Network about Facebook. Co-founder Eduardo Saverin was diluted down from a 30% shareholding to something much lower, vastly reducing his upside in the company. As a public company Facebook is now restricted in how much dilution it can impose on its shareholders. The rights that public shareholders take for granted need to be negotiated in private markets and the resulting terms are an important dimension of the investment proposition.

Fourth, “being in the room”.

As an extension of increased transparency outlined in the first point, a private investor in a company has the capacity to be “in the room” with management. There’s an old saying in public market investing: the stock doesn’t know that you own it. Well, a private company does and that creates opportunities and responsibilities to work alongside management to create value in the company in ways that are often remote in public markets. If it’s intellectual competition that makes public market investing fun, it’s hands-on involvement that makes private investing fun.

The bottom line is that there are various differences between private market and public market investing. Which is why entrepreneurial/financial engineering skills tend to surface more on one side (depending on the maturity of the company) and portfolio management skills more on the other side.

But there are also overlaps. The most significant is that both sides require a deep understanding of a company’s business model and its industry dynamics. In some industries most of the iceberg floats in public markets, and in those industries public market experience may be especially valuable.

Financial services is one example. Challenges around regulation, credit cycles and capital management are well understood by public market investors given the degree to which quoted companies have had to contend with them over the years. Financial services is also a sector where size and incumbency have various advantages that are not always obvious to private investors. In a speech earlier this year Sam Woods, deputy governor of the Bank of England, said, “it is so far notable that no small bank has successfully become a large bank”. The perspectives amassed investing in large banks on public markets can be usefully leveraged to add value to private companies.

Warren Buffet famously straddles both domains. He says of himself, “I am a better investor because I am a businessman, and a better businessman because I am an investor”. The same could be said of private and public market investing. Both ultimately reward insight and being involved across both provides a fertile environment for cultivating meaningful insights.

Originally published at