The risks associated with investing in companies not listed on a stock exchange have garnered much attention following the recent ‘Woodford-gate’ episode.
But early stage companies yet to float undeniably offer huge potential for growth.
Yet, with the opportunity for greater returns comes the inevitable and consequent risk of it all going wrong – not to mention the fact that you could be left holding an investment you can’t sell.
While investing in unlisted companies certainly won’t be for everyone, we take a look at when it can be worth a punt and how to do it responsibly.
Spotify was founded in April 2006 but didn’t IPO until April 2018, when it was worth £27billion
What went wrong for Woodford?
Earlier this month Neil Woodford – former darling of the fund management arena – was forced to gate his once £10billion, now £3.5billion, Woodford Equity Income fund because of a rising exposure to unlisted holdings.
Mass redemption requests had forced him to sell off his more liquid stock holdings to refund investors, but it left the fund with unusually large stakes in smaller and early stage unlisted companies, which are far harder to sell.
The episode led to calls for the Financial Conduct Authority to review open-ended funds’ holdings of illiquid assets less than two years after it conducted investigations into open-ended property funds, which also had to temporarily suspend withdrawals in 2016 following the EU referendum when investors took fright.
It has raised serious questions around whether or not open-ended funds – which allow investors to put money in and take it back out with no notice – should have their ability to hold sticky assets curbed.
Why invest in unlisted companies in the first place?
So why was Woodford so eager to access the unlisted space?
Despite the risks, investing in unlisted companies can be hugely rewarding.
Many firms are focusing on growing – in size, reputation, or otherwise – before listing and some of the world’s most popular tech giants became multi-billion dollar leaders before they eventually listed.
Music-streaming service Spotify had a market valuation of around £27billion by the end of its initial public offering in April last year while more recently, ride-hailing giant Uber raised £8.1billion when it listed last month.
Meanwhile, many software companies are increasingly reaching $10billion in value without going public while multinational professional services company Deloitte, is currently valued at $43billion, yet remains a private company.
As more firms are deciding to stay private for longer, more value is to be found among unquoted companies and it could be argued that the potential reward more than justifies the risk – that is, when accessed through an appropriate investment vehicle.
What is the best way to invest in unlisted companies?
One of the easiest and most common ways is through an investment trust, or closed-ended fund, which is a listed company in itself and can invest in both listed and unlisted shares.
Ian Sayers, chief executive of the AIC, said we should not pretend that the issues around investing in unlisted companies through open-ended funds is new.
Association of Investment Companies chief executive Ian Sayers said: ‘To be blunt, illiquid assets should not be held in open-ended funds.
‘Even if the liquidity mismatch can be handled, the need to hold large tranches of cash to meet redemptions reduces returns.’
By contrast, the investment trust structure is particularly well suited to investing in illiquid assets, such as unquoted companies, because it is closed-ended.
‘Managers do not have to worry about money coming in or leaving the fund as investment companies have shares which are bought and sold on the stock exchange,’ he added.
‘If there is negative news the trust’s share price will fall but the portfolio itself will be unaffected. Investors may not like the share price which will have suffered but they can continue to buy and sell if they wish to.’
Holders of investment trusts are able to access illiquid or hard-to-trade assets (which in turn, usually means riskier) such as private companies but are protected by owning shares in the trust rather than units in the underlying assets themselves.
This is because a trust, as a UK listed equity, is also subject to the same regulatory regime as mainstream listed businesses.
Annabel Brodie-Smith, of the The Association of Investment Companies, said: ‘Having the freedom to hold unquoted companies is a major benefit of the investment company closed-ended structure.
‘Investors may be interested in the opportunities that some access to fast-growing unquoted companies within a wider portfolio of investments can bring.’
Some trusts may invest wholly in unquoted companies and are known as private equity trusts.
They’re lucrative: the average trust in the AIC’s private equity sector has returned 52 per cent over the past five years while the FTSE All Share and FTSE 100 are only up 30 per cent and 27 per cent respectively, according to FE Analytics.
However more trusts outside of this sector, such as those listed in the table below, are starting to take advantage of their closed-ended structure and venturing into the private sector.
|Investment company||% of assets in unlisted firms|
|Woodford Patient Capital||77|
|Tetragon Financial Group||39|
|Henderson Alternative Strategies||45|
|Baillie Gifford US Growth||8.5|
|F&C Investment Trust||7.9|
|Source: AIC. All figures as at 22/05/2019 expect *as at 31/03/19|
The £220million Merian Chrysalis Investment Company was launched last year as a result of the managers, Richard Watts and Nick Williamson, realising the value to be found when investing in a company at the point of IPO, and wanting to tap into the added value to be found before that.
Watts said: ‘$100 invested in Coca Cola at IPO in 1919 would be worth over $1million now. The same amount in Nike when it listed in 1980 would be over $6million. Imagine if you could go back in time and access these companies before IPO. You could capture even more value.’
However, Stephen Peters, fund manager at Barclays Wealth & Investments, said investors should be aware that while investment trusts are a more natural home for unlisted assets, they can trade at a discount to the value of their assets, or be hard to deal in.
He also said costs should be considered as funds investing private assets normally charge higher fees than those investing in traditional equities, as they will often include a performance related element.
He added: ‘There is some concern that the price paid for many of these unlisted assets is too high when compared to their potential growth or profit, with prices driven higher by the large amount of capital seeking a home.
‘Potential buyers should also be aware that traditional equity managers may not have much experience in managing unlisted companies and, if there is a decline in the stock market, or the UK or global economy, then it is unclear as to how well both the investment managers or the companies themselves will perform.’
James Anderson, co-manager of the £7.9billion Scottish Mortgage Investment Trust – which is able to invest up to 25 per cent of its portfolio into such businesses – said the team’s ‘rapid advance into investing in unquoted companies represents [their] greatest strategic initiative of the last decade’.
He said: ‘Traditional public equity markets no longer tempt young and outstanding companies. They often resent the impatience of quarterly capitalism and regulatory burdens.
‘We now regard it as a matter of course that private companies offer us more and more promising new opportunities almost every year than their public counterparts.’
Many software companies are increasingly reaching $10billion in value without going public. Note: Only lists companies founded after 1980; 2015 data are preliminary; some companies excluded from analysis if bankrupt or acquired.
More companies are staying private for longer
The average duration of ownership of a private business in the private market in 2012 was around five or six years from its first funding round to exit. But last year, that figure was 11 years.
Ryan Hughes, head of active portfolios at AJ Bell, said while historically companies may have wanted to list to raise more capital, providing the existing owners an exit opportunity or gain a higher profile with brand awareness, such obstacles are not as severe anymore.
Start-ups at the very beginning of their journey can often find support from angel syndicates – a group of high-net-worth individuals who pool their money in exchange for ownership equity
He said: ‘If a company is already successful and doesn’t need to raise additional capital, it may not be necessary for a company to list. After all, to some degree in listing you have lost control of some of the company as it is openly traded on the market.
‘Some companies come to regret listing and Tesla has shown in recent months that being publicly quoted is not always a positive experience with the constant demands from analysts and the need to hit short-term targets.
‘As a result, maybe we will see fewer companies listing going forwards with more choosing to stay private. Consequently, this may see more investment funds looking to invest away from listed markets, although this does come with some liquidity risk which investors should always bear in mind.’
Electric car manufacturer Tesla listed on the Nasdaq exchange in June 2010. Since being in the public eye, its share price has particularly suffered, albeit in the short-term, whenever chief executive Elon Musk has voiced an unpopular opinion
Other ways to invest in private firms
While investing in trusts exposed to private companies is probably the easiest and least risky way of accessing them, it is not the only way.
Venture capital trusts
Just like an investment trust, a venture capital trust, or VCT, is a publicly listed company run by a fund manager. However it aims to make money by investing purely in small, unquoted, entrepreneurial companies, helping them grow. They come with tax benefits.
Because the companies are considered riskier than established ones, investors can get up to 30 per cent tax relief on income, tax-free dividends as well as tax-free growth.
The Octopus Titan VCT is the UK’s largest venture capital trust and has backed the likes of companies such as Secret Escapes, Zoopla and graze.com.
Alex Davies is chief executive at Wealth Club, which offers a range of investment products with tax relief benefits
Enterprise investment schemes
An EIS, or enterprise investment scheme, is another option but more suited to wealthier individuals. Like VCTs, investors can benefit from a range of tax benefits.
Alex Davies, chief executive at Wealth Club, a service which offers access to a range of VCT and EIS products for high-net-worth clients, said: ‘EIS investors are typically wealthier individuals hit by tax hikes and pension restrictions. Once you have used your pension and Isa, EIS along with VCTs are the last generous – albeit higher risk – tax efficient options available.
‘Moreover, you get access to some really exciting and innovative companies which have a real chance of being the next big thing.’
Crowdfunding platforms are becoming more popular for those looking for the ‘next big thing’.
Seedrs, which invests in start-ups as well as later-stage businesses across Europe, has featured well-known names such as Revolut, Blow and Augmentum.
Chief investment officer Kirsty Grant said: ‘The private capital markets have become so much deeper and richer over the past 10 years. There is a lot more private capital available now, which means going public is no longer the only (or best) option for start-ups wanting large amounts of growth capital.
‘Start-ups delaying going public has resulted in a huge amount of value growth occurring off the public markets.’
Direct via an angel syndicate
Again, more suited to higher net worth individuals who combine their capital to invest into a start-up in exchange for convertible debt or ownership equity. Angel investors usually give support to start-ups during the initial process and when most investors are not prepared to back them.
By investing alongside others in a syndicate, you will be spreading your monetary risk and enhancing your investment capacity by pooling funds with others. A syndicate normally comprises of at least three investors who are investing together.
The UK Business Angels Association offers advice on how to set up a formal syndicate, the responsibilities of a lead angel and more on angel investing.
Security token offerings
A more recent development, security token offers, or STOs, were given Financial Conduct Authority approval in 2018. They are like equity crowdfunding but with a token overlay. STOs combine the same dividend, voting and ownership rights as traditional shares but use blockchain technology.
In typical equity crowdfunding, a company sells unlisted equity to investors but in the case of STOs, they sell security tokens, which are digital representations of those shares and are built and managed via blockchain technology, which claims to be cheaper for both investors and investees.
TokenMarket is just one example of a company helping to raise money for companies via STOs and currently has a base of 170,000 international investors for fundraising clients to tap into.