Written by our market research intern Keaton Stott, edits and visuals by our co-founder Aakash Sundar.
How does an investor look at public security differently than private security?
With the sweeping democratization of capital markets making all types of securities available to retail investors, it’s important to delve into the differences between how an investor would do their due diligence on a private security as opposed to a public security. The key differences are liquidity, the ability to diversify*, and availability of information/disclosure requirements required by regulatory bodies such as the SEC, etc.
One key difference between public and private securities is that public securities are often significantly more liquid than their private counterparts. The fair value of any security is what another investor is willing to pay for it at an exact point in time. Public securities are traded on public secondary markets in which the price is determined by millions of buyers and sellers every day. While this high trading volume can cause significant volatility, it also means that public securities are readily available to be converted into cash at any given moment. Liquidity is an important factor for many retail investors because they usually aren’t sitting on multi-billion dollar war chests like many institutions, or have significant savings like some accredited investors. They can encounter life emergencies that create a sudden need for cash, or find another security at a more attractive valuation and have the freedom to shift around their portfolio in a timely manner. On the other hand, private securities are much less liquid. Often they aren’t traded on any open market so the initial investors are along for the ride until an exit is available either through a buyout or an initial public offering. The average holding period across private equity in North America is 6.9 years. This trend has also been increasing over time as in 2007, the average holding period in the same geographic region was 5 years. This means that investors in private securities must be willing to accept a long term investment plan in which their cash is tied away for multiple years until an exit opportunity arises. They also must be able to afford to have this cash tied away while still being able to pay for their day-to-day expenses.
Another key differentiating factor between public and private securities is ability to diversify. Public investors have the luxury of allocating their investments across a wide range of different sectors to minimize unsystematic risk. Traditionally, private securities require a large initial investment which would represent a large percentage of an investor’s portfolio. However, there are now many fractional investment platforms that require low minimum buy-ins are significantly decreasing the lack of diversifiability for private investors. Retail investors can buy shares in private companies for as low as $10, as opposed to the average minimum buy-in of $25 million for a higher dollar private equity fund. This means that an individual with $25 million to invest can now allocate their money across tens of thousands of different private equity securities through an investment platform for the same price that they could invest in a fund that would often allocate the money across 1-10 companies.
The final and most significant difference between public and private securities for a retail investor is information availability. Publicly-traded companies are required to file audited annual financial statements, which inform investors about the financial health and performance of the company. This allows educated investors to perform valuations to arrive at a target price that makes sense for them to invest. With private companies, no such information is usually required (depending on the type of offering) so it requires much more of a strategic perspective rather than a financial perspective — and a significantly higher risk appetite. Investors must value the company based on their thesis about the future of the industry, and their confidence in the management team to execute their goals, along with what financial information the operator or General Partner choose to disclose.
In conclusion, an investor must look at public and private securities through very different lenses. Public securities are more liquid, have more information available, and used to be more diversifiable. However, private securities allow investors to allocate based on their personal strategic outlooks on the future, and often achieve higher returns than in the public markets. The advantages of public securities have kept investors away from private equity for some time now, but the financial industry continues to evolve and create new opportunities and markets to achieve greater returns.