Principles to Consider When Investing in Private B2B Markets

• June 06,2023

Private B2B markets continue to hold a strong appeal, despite occasional periods of turbulence. Esteemed endowment funds like Yale's and Harvard's have recognized the long-term return potential and diversification advantages of private markets. This approach has also inspired private investors, such as family offices and successful tech entrepreneurs, who have the flexibility to allocate more funds to this space without immediate liquidity requirements.

In addition to the financial benefits and diversification aspects, there is a qualitative allure to participating in shaping the future. This resonates with private investors, evident in their investments across venture capital, growth equity, and buyout strategies.

Unlike public B2B markets, which generally operate with greater efficiency, navigating private markets demands greater attention. Here are some essential principles to consider:

Identifying Valuable Opportunities: 

The significance of sourcing and selection cannot be overstated when investing in private B2B markets. Adopting a disciplined approach to cut through the noise can make a substantial difference.

Two crucial questions need to be answered: how to choose which opportunities to invest in and from which pool of opportunities to select them.

The first question pertains to due diligence conducted during the selection process. It involves considering relevant data points and applying appropriate models to validate and stress-test them. Apart from data rooms, qualitative factors like market reputation and team culture can provide valuable insights. It is essential to note that past performance does not guarantee future results. When considering an investment in funds, due diligence should extend beyond past performance figures and consider changes in the context and fund itself. Factors such as the fund's performance history, fund size, team dynamics, and strategy should be thoroughly evaluated, rather than solely relying on well-known names that might have undergone significant changes.

The selection process often requires dedicated resources to review materials, challenge assumptions, and conduct reference calls. Given the time-consuming nature of this process, it is important to be realistic about what can be achieved with the available resources.

Having a robust decision-making process for selecting opportunities is not sufficient on its own. It is also crucial to ensure that the opportunities are sourced from the right pools. Mapping and segmenting the B2B market, understanding benchmarks, and gaining exposure to various opportunities can be beneficial in making informed choices. Collaborating with independent experts and advisors can assist in overcoming information asymmetry, provided there is an alignment of incentives and deep industry knowledge.

Accessing Opportunities: The Art of the Deal

After sourcing and selecting an opportunity, the next challenge is securing an allocation. You may have identified the door to knock on, but will you be allowed in?

While there is a trend toward democratization in private markets, the reality is that many top opportunities, including funds, co-investments, and direct investments, remain oversubscribed and difficult to access.

As a new investor in private B2B markets, you should question whether you are being offered an allocation to an opportunity simply because more sophisticated investors have reservations about its potential. This risk of adverse selection is particularly relevant in co-investments. This does not imply rejecting every deal that accepts your investment, but rather being intellectually honest and understanding why you are being given a seat at the table.

Building long-term relationships and providing strategic value are two critical factors that determine access to otherwise hard-to-reach opportunities. While having substantial capital can be advantageous, it is not the sole determining factor.

Investing directly in private companies helps to establish relationships with the leadership team before fundraising. The same applies to accessing top-quartile funds, as existing relationships between fund investors (LPs) and managers (GPs) often develop over extended periods. Even during challenging market conditions, existing LPs might prioritize deepening relationships with proven performers rather than exploring new GP relationships.

Additionally, GPs may prefer working with sophisticated LPs who offer industry knowledge, and connections.

Constructing a Portfolio in Private Markets: 

Beyond Traditional Approaches When it comes to portfolio construction, there isn't a one-size-fits-all approach. Various factors, such as risk appetite, cash flow, and liquidity needs, influence an investor's optimal strategy. What's crucial is to consider how private markets fit into a broader portfolio and ensure diversification within the private B2B markets portfolio itself.

As companies remain private for longer periods, investing beyond publicly listed assets allows for capturing more value. Private markets provide exposure to the real economy, which is typically less correlated with traditional assets. Their lower liquidity can act as a shield against volatility and inflation, as their fair market values are not frequently updated.

However, it's important to thoughtfully allocate capital across private markets.

A key consideration is whether to primarily invest in direct opportunities or funds for portfolio construction. Both options have their advantages. Combining them is also possible.

Direct investing offers the potential for higher returns and closer involvement with companies. However, it carries the risk of losing the initial capital if opportunities are not selected wisely. It often requires a significant time commitment to build and support a portfolio. 

Accessing high-potential opportunities directly can be challenging due to competition from top-tier funds. On the other hand, investing in funds may provide less direct involvement and potentially lower returns, but it offers diversification from the start and brings valuable discipline and expertise to the portfolio if selected correctly.

Diversification should go beyond mere volume. It's essential to consider multiple dimensions, such as investment stage, geography, sector, strategy, and vintage. Early-stage investments may offer greater potential rewards but have a longer investment horizon and more uneven returns distribution. Late-stage investments may be less exciting but provide a smoother ride with shorter timeframes.

Geographical considerations involve choosing between mature markets like the U.S. and Europe or emerging markets. While emerging markets hold untapped potential, they require specialized skill sets and can be challenging to navigate during turbulent times.

Sector preferences should be guided by more than trends and gut feelings to avoid undue risk concentration. Striking a balance between value and momentum investing approaches is crucial. A predominantly value-focused approach may result in assets that never rebound, while a momentum-focused approach may lead to overpaying and increased volatility.

Considering vintage diversification is also important. Instead of timing the market, investors should consider splitting their capital across different vintage years to balance exposure to market cycles.

While synergy with existing portfolios can be beneficial, attention must be paid to the underlying growth drivers of each opportunity to avoid excessive exposure to specific market shocks.

Constructing a portfolio in private B2B markets that aligns with multi-generational wealth goals, time horizons, diversification, and liquidity needs requires a methodical and granular approach.

Time Horizon: Patience and Understanding the J Curve

Investing in private B2B markets is not suitable for those seeking short-term goals. Unlike public markets, private market investments, such as venture capital, growth equity, or buyout strategies, often lack immediate liquidity options and require a longer time horizon. Patience is necessary to allow investments to mature and reveal their outcomes.

The timeline of private market investments is influenced by factors beyond an investor's control. For direct investments in venture or growth-stage companies, the timeline depends on the company's ability to achieve significant milestones, its capital requirements, and its ability to secure additional funding. While investors can provide assistance, the ultimate success lies with the company's management team. In the case of investing in funds, investors have even less control over timelines.

Understanding the concept of the J curve is essential for private B2B market investors. In the early years of a fund, there may be significant cash outflows as investments are made and operating expenses are covered. Over time, as the fund's investments mature and generate returns, the fund's value may start to rise, potentially exceeding the original investment amount.

Interpreting portfolio updates from a fund investor's perspective requires considering the J curve dynamics. A mark of 1.0x indicates that the capital invested matches the value of the investment in the fund. However, immediately after an investment is made, the mark is likely to be negative due to front-loaded fees typically charged by funds.

Private equity funds, for example, charge a 2% management fee on committed capital annually but may only call a fraction of the capital in the first year. This can result in a mark below 1.0x, representing an apparent initial loss. As capital continues to be deployed and the underlying assets start generating yield, returns normalize over time.

Unlike public investments, where capital is deployed all at once, private market funds call capital to fund investments as they are closed. Investors commit to honoring capital calls to avoid defaulting on their obligations. Full deployment of committed capital typically occurs within 3 to 4 years, and sometimes funds may not fully call their commitments if distributions begin before all capital is deployed. Different investment strategies have different J curve profiles, with venture capital having the longest and secondaries having the shortest timelines. Considering these timeline differences helps construct a portfolio that aligns with an investor's liquidity requirements.

Alignment of Interests: 

Ensuring Balanced Incentives When directly investing in a private company, investors find comfort in knowing that the core team members have a significant equity stake and are motivated to drive the company's success. This aligns with the trend of universities reducing ownership stakes in their spinoff companies. Down the line, more sophisticated investors also look for leadership teams with substantial stakes in the businesses they run. If the investors win, the team also benefits.

In the case of investing in funds, there is an expectation that general partners (GPs), and ideally the broader team, have a share in the fund's profits as a key incentive mechanism. GPs are also expected to have skin in the game, risking their own capital if performance falls short. The idea is that they only win if the investors win and lose if the investors lose.

Fee structures play a crucial role in aligning interests between investors and fund managers.

Management fees are typically a percentage of committed capital or assets under management, ranging from 1.5% to 2.5% annually. These fees cover the fund's operational expenses, including hiring professionals, conducting research and analysis, and other costs.

Usually, 80% of the profits are distributed to limited partners, while the remaining 20% is retained as carried interest by the fund managers. However, this fee is charged only after a predetermined hurdle rate, such as an 8% internal rate of return (IRR), is achieved.

This fee structure ensures that the interests of the fund managers are aligned with those of the investors, motivating them to deliver strong returns. Given the illiquid nature of private B2B markets and the expertise required, these fees are considered a necessary trade-off for accessing the potential outperformance and diversification benefits offered by private equity funds.

Another indicator of alignment is the proportion of capital that fund managers reinvest in their own fund, known as GP Commitment. While the industry average for GP Commitment is around 2%, it can range from 1% to 10% or more. The exact percentage depends on factors such as fund size, the track record of the fund manager (with more flexibility for emerging managers), and the terms agreed upon by limited partners (LPs) and the GP.

It ensures that they share both the risks and rewards of the investment. Selecting fund managers who are experienced, skilled, and deeply invested in the fund's success is crucial. It's important to note that meaningful skin in the game can vary across key team members based on their net worth. Understanding if and how this commitment is ingrained in the firm's culture, from the junior level upwards, is valuable.

Is it worth paying higher fees? As always, it depends. Unlike choosing a listed ETF tracker where expected performance is generally similar and the biggest differentiator becomes the effective expense ratio, venture capital, and private equity investments might justify higher fees if they provide access to highly curated opportunities that might not be available otherwise. In other words, paying a 20% performance fee for an opportunity that could double the initial investment is preferable to paying only 10% for an opportunity that may not perform at all or, worse, result in capital loss. When comparing different opportunities, it's advisable to consider net returns.

New investors should be cautious of funds that rapidly increase their asset sizes, as this may indicate a motivation driven solely by recurring management fees rather than performance. As a rule of thumb, managers with a more performance-driven incentive system and a significant GP commitment ensure the highest alignment of interests.