Time to consider private market technology?

Technology has been one of the most significant drivers of business growth in the last 20 years. The S&P 500, an index comprised predominantly of industrials three decades ago, has seen a significant step change.

Last year was the first time in 42 years that the top five components of the S&P 500 represented 20% of the index and all five members belonged to the technology sector.

With increased scrutiny on the sector, big tech has continued to enhance market performance, cementing itself at the heart of the composition of many portfolios and is arguably not done yet.

New world opportunities

With next generation technology such a 5G broadband happening, a “new world” could already be here. But it is crucial that the technology is made widely available in order for the Internet of Things (IoT) to become reality.

Furthermore, big data and cloud computing is more and more becoming the norm as opposed to the hardware servers seen in the past. Another key trend is electronic components, like semiconductor chips, getting smaller and allowing them to integrate in every object from washing machines to clothes.

Going private

While accessing technology through public markets could be a way to tap into this longer term growth profile, high and volatile valuations make it harder for investors to pick companies.

Also as companies get larger, the impact of their innovation tends to fall significantly. However, a solution which could accommodate getting access to innovation and technology in a more disruptive fashion and at an earlier stage is private markets.

By accessing companies in these sectors early on and through quality managers with experience in identifying and managing target companies, investors could play a vital part of the innovation process.

What’s more is that the opportunity set ranges from venture capital, growth and more mature private equity strategies, meaning investments can be more closely aligned to risk preferences.

Key trends

There are two key trends that appear to be forming and make investing in technology through private markets attractive.

Firstly, the opportunity set appears to be more favourable. Companies seem to be staying private for longer with around 80% of the value creation accruing to private investors, according to Carlyle¹, a private equity house. In fact, the average median age of tech companies filling for initial public offerings (IPOs) has grown from about 5 years to 12 years a decade later and valuations at the IPO stage have consistently been higher.

Secondly, whilst public market opportunities are arguably expensive, valuations in private markets still remain attractive. Data from Pitchbook and Bloomberg show that the 2021 estimated median EV/EBITDA multiple for private markets is 13.9x. This is notably lower than the 15.5x multiple for tech companies in the NASDAQ 100.

Private market valuations are also usually less affected by market volatility and direct exposure to target companies helps mitigate the issue of valuing intangible assets.

Potential risks

As with any investment opportunity, there are some risks to consider. Private market funds can be locked up for a significant period of time with restrictions on the transfer of shares. Also, investing in unquoted and unregulated investments requires further due diligence than quoted investments.

Finally, underlying investments may be highly illiquid/immovable making valuing it for sale and realising the fair value it records from time to time harder to obtain. Therefore, investors must be aware of the illiquidity premium that comes with investing in private markets and be willing and able to commit to investing for the longer term and locking up capital. This also stresses the importance of manager selection to make such a commitment worthwhile.

Portfolio diversifier

Investing through the private market appears to offer an affordable way to access technology disruptions. Disruptions that are likely to continue infiltrating all aspect of daily activities, allow greater access to target companies and innovation benefits early on, and act as an important diversifier in a balanced portfolio.

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