Small business investment has gone mainstream – or has it?
While individual private investors looking to back early-stage businesses are spoilt for choice as crowdfunding gathers pace, opportunities for them to provide private equity backing to more established SMEs remain scarce.
Investing in such businesses is often more complex, but usually offers a better risk/return profile. We’re talking about two quite different types of investment here. Venture capital investing presents the possibility of returns worth many times the original investment – if you pick a winner.
The flip side is that there’s a far greater likelihood of losing your stake altogether. To balance the risk, investors need to have quite a wide range of venture capital investments in their portfolios.
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With private equity investments – i.e. growth capital for longer-standing businesses, or funding a change of ownership through a management buy-out (MBO) or an equity restructuring – investors are less likely to see 10 or more times their money on exit.
But equally, they have a far greater probability of seeing a return overall, particularly if the investment has been structured and managed correctly. Indeed, figures from the British Venture Capital Association show that small MBOs are the most consistent longer-term performer of any private equity or venture capital investment stage – providing 39.2 per cent internal rate of return over 10 years (compared with 4.6 per cent for venture funds).
There are several reasons for this. Later stage businesses are more robust, with visible revenue streams and profits: they don’t need to prove their concept or routes to market. Management teams are well-established, therefore less reliant on just one or two key people, reducing risk.
Exit prospects are better – since they are already more mature, time required to position the business for exit is often shorter. Moreover, there are likely to be more exit options available on the secondary market or through a trade sale. Such buyers usually won’t be interested in a business until it has reached a certain size.
But for private investors, access is a stumbling block. Although crowdfunding platforms are starting to broaden their company focus beyond startups, the average age of investment prospects is currently only just over three years, according to AltFi Data. You’re unlikely to find private equity opportunities run on a crowdfunding platform.
Why not? First, later-stage investee companies are often highly sensitive to having commercial information publicly available. Second, there is the deal management factor. Investments like this require an institutional approach which needs to be managed by an experienced party, both pre and post deal.
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Given the wide variety of parties involved, a great deal of coordination is required complete the deal. Due diligence is more complex. Most crowdfunding platforms are simply not set up to navigate this level of complexity: it needs full-scale private equity treatment.
Equally, deals of this type need on-going professional management of the investor syndicate – again, something which is not par for the course with crowdfunding. This is especially important on exit. A fragmented or dis-unified investor base could deter potential buyers, adversely affecting the firm’s valuation.
Investors also need the relationship with the portfolio company to be actively managed on their behalf – not least to ensure that appropriate legal protections are in place to safeguard their interests as minority shareholders.
This sounds like a tall order. But we are now starting to see more platforms opening the door for sophisticated private investors to participate in private equity deals by providing a more structured syndication approach. The idea of investing via an innovative “experienced investor collective”, where private equity professionals take on the role of institutional investor on behalf of multiple clients, is gaining traction.
There’s a certain thrill factor in investing in a new business. But more established SMEs can be just as exciting – while being a less uncertain proposition for investors. The prospect of superior risk-adjusted returns is an attractive one. Why should institutional investors have them all to themselves?