A Whole New Investment Universe for Many
Anyone who has read Investing Beyond’s weekly articles over the past few months can gather that, as far as the private markets are concerned, I have erred on the side of caution, being careful to ensure that the reader is educated regarding risks and considerations of private markets. While this is a space that I am completely comfortable in, the truth is, for many Canadian investors, this is a brand new world. In order to offer as much balance as possible, today’s article will highlight some of the great benefits you should seek out in the private markets, which are the reasons we invest in the first place.
#1- Look For: Calibre of Investment Management
Over the past 4 years I have witnessed an increasing number of extremely talented and capable people migrating to the private space. Some of these individuals are amongst the highest calibre that an investor could want to be associated with, including:
- London Business School MBA with previous experience managing private equity for one of the largest European banks
- CFA and Registered Portfolio Manager who was previously a VP Corporate Finance for a “Big Four” accounting firm
- Former derivatives trader, and head of risk management, for some of the world’s largest financial institutions
- MBA, CFA who was former VP Global Money Markets for RBC Dominion Securities
- MBA, CFA who founded a respected investment banking firm in the Middle East
- CFAs who have experienced many decades of private equity success
- CFO of one the largest and most successful publicly traded oil and gas companies in Western Canada
The above is a sample of the extremely high level of sophistication, expertise, and risk management processes that add value to the exempt private markets universe in Canada.
#2- Look For: Preferred Yields
One of the pet peeves I have personally, based on 17+ years dealing with public market investments, is that many times the investor is in last place for returns. You can buy a standard mutual fund, for example, pay the MER (management fees) on a quarterly basis like clockwork, and are only rewarded if the markets rise. Your financial advisor, and the investment firm, are always paid, even if zero returns are generated. On the other hand, many exempt market cashflow products put the investor as close to first place for investment returns as possible. Under some structures the investor will own a preferred unit, meaning returns generated will go to the investor first, and management will only participate in profits if they have executed on the investment premise and generated sufficient return. This structure creates management that are highly motivated to produce returns for investors. This is what is referred to as proper investment alignment.
#3- Look for: Opportunities for Classic Value Investors
Many investors like the idea of purchasing an asset at a discount to its intrinsic value, similar to Warren Buffett, also known as value investing. When we examine today’s publicly traded markets, the S&P/TSX 60 Index for example, sits at an extremely high 23x trailing earnings. That basically means that you are buying the average stock and extrapolating the next 23 years earnings onto it. As the p/e ratio for the TSX has historically averaged closer to 15x trailing earnings, by any long term measure, the Canadian stock market is very expensive. In fact, there have only been two times in history where the TSX has had a trailing p/e this high. The first was prior to the 2000 technology bubble crash. The second was in early 2008 prior to the crash resulting from the financial crisis. There do not seem to be many opportunities for value investors in the public markets today.
On the other hand, the private markets contain a number of investment products that purchase assets at a much cheaper level, and could also fit a value investors’ criteria much better. For example, there is a project that recently purchased an asset for $15 Million dollars. That asset is currently generating annual cashflow of $4 Million. The trailing p/e for this asset is less than 4x. Value investing dictates that the cheaper price you pay for an asset in relation to its earnings, the greater the margin of safety, and the more upside potential of the investment. As far as I know it would be next to impossible to purchase assets this cheaply on the TSX.
#4- Look for: Back-End Profit Participation
Many investors enjoy the regular cashflow provided by preferred units. In addition, they also desire to participate in potential back-end growth opportunities, and profit alongside management. There are a number of private exempt market offerings which offer back-end profit participation to the investor, upon project monetization or exit, provided there are profits to distribute. A common structure could be:
- Investor receives preferred units which pay a target preferred annual yield, say 8%, paid monthly
- Investor also receives 50% of any back-end profits generated upon project exit (if any)
- Management receives the other 50% of profits (if any)
- Back-end profits for both investor and management only realized, after preferred units are paid annual target yield, plus principle returned
This structure is extremely investor-friendly. Especially when compared to many traditional investment structures such as mutual funds.
#5- Look For: Simple to Understand
Many private exempt market offerings require what is known as patient capital. If private apartment buildings, oil and gas assets, farmland, etc are acquired, as they are not publicly traded on an exchange, the unit price of the investment generally fluctuates very infrequently, if ever, until project completion. Public market investors are bombarded daily by BNN, CNBC, Bloomberg, second by second updates, news flashes, trading strategies, and the millions of opinions can generate a lot of noise, and this can become quite confusing. On the other hand, a private project can be extremely easy to understand, for almost any investor. For example:
- Money is raised from investors to form a partnership
- The partnership acquires small cashflow producing assets
- The assets pay a regular, fixed, target yield to preferred unitholders
- A number of small assets are acquired and aggregated to form a large asset
- The large aggregated pool of assets attracts institutional interest and is sold to an institution such as a pension plan
- The sale of assets provides an exit to investors. They may receive a portion of profits upon sale.
This is a simplistic example, but in theory, is how many private exempt products work.
This article was intended to inform you, the investor, about some of the main benefits to look for when investing in the private markets, which is a tremendous evolution from even 5 years ago! Of course, an investor needs to be armed with all appropriate information about any investment, including risks, fees, liquidity constraints, etc. Private capital investing is already an established asset class among many institutional investors. Where appropriate, it can be used as a complement to traditional stocks, bonds, and mutual funds. Make sure you consult a qualified professional prior to investing.
If you have any questions about improving your portfolio, I’ll gladly make time available on my calendar to point you in the right direction as a sincere thanks for taking the time to visiting my website…click here to reserve your time