The private road to tech
That is a million (or perhaps trillion) dollar question prospective investors would dearly love to know the answer to. Many could be forgiven for casting an envious glance at the baby-boomer generation, whose pension savings will have been boosted by the tech sector’s outsized returns of the past several years.
The signs are, though, there will be plenty more such investment opportunities in future. Software, for example, remains the fastest-growing sector globally, with an expected compound annual growth rate of 15.6% through to 2024. And, while Internet use has surged, there is still much further to go, with 41% of the world still lacking access to the web. Then there’s 5G. Together with the Internet of Things, the next generation of wireless technology promises to take connectivity into uncharted territory.
As digital technologies become a bigger part of our lives, a new cohort of disruptive companies will emerge. Some of these firms will become household names. Others will have a Slower public profile but still provide strong investment returns. Many more, however, will fail.
Indeed, while the opportunities are vast, investors in the tech sector need to tread carefully. To begin with, regulation is a big risk. Governments and antitrust authorities are clamping down on data privacy and looking at new ways to tax the sector.
Valuations also require great scrutiny. The digital revolution – which has been given added momentum by the effects of the Covid-19 pandemic – has propelled tech stocks to remarkable levels. Relative to their own history, valuations for listed tech stocks are higher than for virtually any other sector. The price-to-earnings ratio for constituents of the MSCI ACWI Tech index has surged to 25, compared to a 10-year average of 15.7.
Yet listed tech companies – expensive or not – are no longer the only option for investors. The private sector is an increasingly attractive alternative. Not only are valuations more reasonable, but private firms also account for a bigger proportion of the investible universe.
Private companies are certainly proliferating – seemingly at the expense of their listed counterparts. Since 2000, the number of listed companies in the US has fallen to 4,000 from 7,000. And, those who do list do so at a more mature stage – the median age of a company going public in the US has risen from an average of seven years in the 1980s to 11 years between 2010 and 2018.
This is particularly true in tech. Here, the availability of private capital has enabled companies to delay listing for longer. In the US alone, private equity and venture capital investment into software has more than tripled since 2010 to USD 96bn. Staying private for longer suits tech firms because small, rapidly growing companies tend to have significant intangible assets. Typically they do not want to disclose their early stage research publicly and therefore favour a closed group of shareholders; they can also benefit from private investors’ greater flexibility in assessing the value of those intangible assets.
Consequently, by the time of the IPO tech companies tend to be more mature, potentially past the period of ultra-fast growth – and high investment returns. So while Amazon, Apple and Microsoft all listed more than a decade ago with valuations of under USD 1.5bn, recent IPO stars have been valued at much, much higher levels – including music streaming service Spotify at USD 26bn, cloud-based data warehouse firm Snowflake at a USD 33bn, video-conferencing provider Zoom at USD 9.2bn and cloud monitoring specialist Datadog at USD 7.8bn at IPO (see chart).
Today’s tech companies IPO at much higher valuations than their predecessors
Crucially, as companies stay private for longer, a growing share of their investment value is created prior to listing. Investors in private markets have much greater scope to nurture the businesses they invest in, increasing its chances of success. In leveraged buy-out (LBO) deals, the ability to own a majority in investee companies allows for less distraction from minority shareholders or equity analyst recommendations. In venture capital (VC) deals, meanwhile, founders will be looking for value added partners, i.e. investors that are more than just financial partners and that can bring a true expertise and often contacts. Thisis in stark contrast to the big listed names where even the largest of investors hold only a tiny fraction of the shares and thus have limited say on the board.
Alignment of interest is also key:managers of PE and VC funds tend to have a meaningful part of their own capital allocated to the investments they pursue. We believe this is a key factor driving stronger returns in PE/VC, and that selecting the right partners to invest with is paramount. Furthermore, private companies don’t suffer the same kind of pressure to meet or beat market expectations with quarterly earnings. They can afford to spend time shaping the business for success over the long run even if that means sacrificing profitability in the short run. In PE, the investment horizon is on average around five years, so you can set a multi-year business plan for five years rather than a quarterly one.
Thanks to the recent growth of the PE universe, investors now have the potential to spread investments across companies of different maturities rather than just focusing on high-risk early start-ups. We see this as the best way to mitigate the level of risk, while maximising return.