Practical analysis for investment professionals
13 November 2023

The Innovation Advantage: Private Market Investing

Innovation Drives Value Creation

Innovation has always propelled economic progress and wealth creation. Investors once accessed the growth of groundbreaking companies through the stock market after these innovative firms went public.

But the investment landscape has dramatically shifted in recent decades. Companies today often delay their initial public offerings (IPOs) and stay private for longer or forever. From 1980 to 2000, the IPO market averaged 325 transactions per year. Since 2000, that number has dropped dramatically, to an anemic 135.

To invest in the growth of innovative new companies, we need to look to the private markets.

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Innovation and the Private Markets 

How have the public markets changed? One example of the IPO heyday is Apple Computer. Apple went public in 1980, only a few years after its launch, and raised $100 million on $117 million in revenue. Just four years later, the company clocked $1.5 billion in revenue and put more than 10x growth in the pockets of public investors.

But 1980s Apple-like returns are anachronistic in today’s much-diminished IPO market. Pre-IPO investors are harvesting the bulk of the returns from the current crop of early stage high-growth companies. That’s where the transformative opportunities are.

Private market investors have traditionally backed early stage, high-potential, fast-growth companies through venture equity. Though the barriers are falling, early stage equity is often an insider’s game that even the top investors can’t get in on. But venture debt has recently emerged as an attractive complement, providing investors with another way to access “innovation” as an asset class. As new firms grow, they often look to venture debt for funding to reduce their cost of capital and decrease their ownership dilution. Venture debt vehicles give market participants who missed out on the earliest equity rounds the chance to invest in the company’s future.

Ultra-high-net-worth (UHNW) individuals have recognized the opportunity, and family offices have shifted their investment focus accordingly since the global financial crisis (GFC). Institutional investors have followed their lead. The numbers don’t lie. Direct investing in private transactions has increased 175% in the United States and 210% globally in the last 15 years.

In August 2022, Blackstone announced plans to invest $2 billion in private technology loans, including venture debt, in a major lending push to private start-ups and tech companies. A year later, BlackRock acquired Kreos Capital, one of Europe’s largest private venture lenders.

As Stephan Caron, head of EMEA Private Debt at BlackRock, observed, “Current market dynamics have made private credit an attractive asset class as investors focus on its income generation, low volatility, portfolio diversification and its low defaults versus public markets.”

The potential advantages of private market investments, specifically venture equity and venture debt investing, extend to five dimensions of performance.

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1. Portfolio Diversification

Allocations to pre-IPO equity and debt can help diversify a portfolio and disseminate risk across sectors, stages, business models, and regions, among other factors. They can also mitigate the impact of underperforming public markets and shield us from market fluctuations. Indeed, pre-IPO companies often exhibit low correlations with stocks and bonds and improve risk-adjusted returns. This is especially critical as the ranks of publicly listed companies thin out. There were roughly 8,000 listed firms in 1980. Now there are only around 4,000.

2. Growth and Return Potential

Companies often enjoy their fastest growth trajectories early in their life cycles, especially during their pre-IPO stages. That is when their value tends to appreciate the most as their market share expands. 

Venture debt meanwhile has consistently delivered annual income in the mid to high teens on top of another 3% to 5% in annual returns from equity participation. Moreover, across the industry, the annual loss rates on loans have been below 0.50% over the past 20 years.

US Private Equity and Venture Capital Index Returns*

IndexSix MonthOne YearThree YearsFive Years10 Years15 Years20 Years25 Years
CA US Private
Russell 2000
S&P 500
Venture Capital
Composite mPME
Russell 2000
S&P 500
Composite AACR
Russell 2000
S&P 500
* Periods ended 30 June 2022
Source: Cambridge Associates

3. Early Access

Start-up investing gets us in on the ground floor of high-growth companies and provides a first-mover advantage that can lead to more favorable investment terms. At such a nascent stage, a company has lower valuations and higher upside. The Apples, Alphabets, Netfixes, and other industry disruptors all began as start-ups and generated staggering profits for their early investors.

What do we mean by “staggering”? Early Uber equity investors offer a good example: First Round Capital’s initial $510,000 investment turned into more than $2.5 billion when the company went public. Sequoia Capital’s $260 million investment in Airbnb became $4.8 billion 11 years later. Early SpaceX investors might soon see a similar payday: Founders Fund invested $20 million in 2008 when the company was valued below $1 billion. The most recent private funding puts SpaceX’s value at $137 billion.

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4. New Ideas

Investing in venture equity and debt funds and directly in start-ups can also give us insights into emerging trends and technologies and a better understanding of the broader market outlook and how it is evolving.

With fewer and delayed IPOs, the public markets are only the tip of the opportunity iceberg. The bulk of business innovation is hiding unseen beneath the surface in the private markets. This gives private market investors an information advantage over those who can’t see the deal flow. Private company reporting has yet to be commoditized like its public counterpart, so informational asymmetries abound for those who know what to look for. Private market investors get their data from the proverbial horse’s mouth, from the people building the young companies that will shape the future.

5. Untapped Markets

Private firms often target niche and underserved markets and segments that their larger, more mature peers overlook. By identifying and investing in start-ups with specialized products or services, we gain exposure to unexplored markets and their growth potential.

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The changing investment landscape demonstrates the valuable role private market investments can play in our portfolios. Not only can they enhance portfolio diversification, but they can also improve risk-adjusted returns and set us up for potentially exponential growth.

Let’s face it. The outsized returns that successful innovation generates are no longer the preserve of the public equity markets. To position ourselves at the vanguard of economic progress and wealth creation and invest in innovation today, we have to go private. And that means looking to venture equity and venture debt.

In future installments of this series, we will delve deeper into venture equity and venture debt and how to invest in them.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images / Eoneren

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About the Author(s)
Cynthia Harrington, CFA

Cynthia Harrington, CFA, is a serial entrepreneur with successful education technology and investment management companies. She worked with pioneering crowdfunding company Issuance and helped dozens of firms raise Reg A and CF funds. She has consulted for start-ups on successful fundraising from early stages up to $60 million rounds. Harrington sold her SEC registered large cap value manager in 2000. As an award-winning journalist, she has written more than 400 articles for CFA Magazine, Fraud Magazine, Accounting Today, Financial Engineering News, and Journal of Accountancy, among other. She co-authored two textbooks: Corporate Finance for the CFA program, and the Association of Certified Fraud Examiners’ course on Financial Statement Fraud. Harrington was cited as one of the "fifty prominent authorities on performance measurement," She holds the chartered financial analyst (CFA) designation. Harrington is COO and founder of Studious Technologies, Inc., transforming professional education with AI personalized learning and TutorAI.

Zack Ellison, CFA, CAIA

Zack Ellison, CFA, CAIA, is the founder and managing partner of Applied Real Intelligence (A.R.I.) and the CIO of A.R.I.’s Venture Debt Opportunities Fund. A.R.I. is an investment management company focused on providing debt financing solutions to innovative, high-growth, venture capital-backed technology companies. Ellison leads A.R.I.’s investment activities, including sourcing, due diligence, structuring, execution, and portfolio management. Previously, Ellison was director of US Public Fixed Income at Sun Life Financial, a corporate bond and CDS trader at Deutsche Bank, and an investment banker at Scotia Bank. He served on the board of CFA Society Los Angeles from 2020 through 2023 and in 2021 was the recipient of the society’s Emerging Leader Award. He currently serves on the board of the Southwest Chapter of the CAIA Association and as a member of the Milken Institute Young Leaders Circle. Ellison holds an MBA from the University of Chicago Booth School of Business and an MS in risk management from NYU Stern. In his personal time, he is studying for a doctorate in business administration at the University of Florida. Additionally, he holds the CAIA designation, is a CFA charterholder, and previously held FINRA Series 7, 55, and 63 licenses.

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