Imagine that it is July 31st, 2015 and you are an investor who just purchased $1 million of Valeant Pharmaceuticals (VRX) stock. Fast-forward May 17, 2016. That $1 million investment would have plummeted in value to $123,416. If you had instead chosen to invest $1 million in XLV, the S&P healthcare ETF, you would have $905,471. Not necessarily a positive return in value. But not a complete wipe out of it either.
It is easy to see how diversification can dramatically increase both the return and diminish the risk of a portfolio. The massive influx of capital into ETFs in recent years (global ETF assets now exceed $3 trillion) is certainly evidence of the value that investors place on diversification. Yes, this is partially driven by cheaper fees, but it can also be attributed to the inherent diversification implied in the underlying ETF.
Public market investors diversify their holdings for down-side protection or to rebalance their portfolio. By buying and selling certain assets, investors can maintain their desired level of asset allocation and effectively manage their risk exposure. These are not only common, but encouraged, diversification tools in public markets. Yet, in private markets, the selling of private company securities is often stigmatized. Why the disconnect?
This misguided sentiment has largely been driven by the admittedly inflated value of so-called “unicorns”, startup tech companies valued at over $1 billion. Fidelity Investments reportedly cut the valuation of many of the startups that it holds a position in earlier this spring. This well-publicized development has led many to believe that private market selling equates to a lack of confidence in the companies themselves. Sure, there is truth that the value of many startups has become magnified, but it is important to not let temporary news diminish the real value and long-term benefit of private market investment diversification and portfolio rebalancing.
The reasons why an investor might want to sell/rebalance their investments in private companies are very similar to why that same investor might sell their public market holdings. If a hedge fund trader had invested exclusively in large-cap oil producers 20 months ago, that investor would have lost about 35% of his net worth. Meanwhile, investing in SPY, the S&P 500 ETF, would have yielded a small profit over the same investment horizon. For the exact same reason, it is equally imperative for private market tech investors to diversify their holdings across subsectors, including hardware, cloud, IOT, etc. Diversification is not limited to startup specialty. Investing across funding stage, firm size, and geographic focus can also protect a private stock investor from downside portfolio risk.
And let’s not forget about simply mitigating exposure to a company’s idiosyncratic risk. As we saw earlier with our VRX example, let’s consider an investor who held a significant amount of their equity in Theranos, the privately held medical laboratory services company that now finds itself at the forefront of a regulatory probe. During the summer of 2014, Theranos was valued at roughly $9 billion. Now, after Federal investigations into the company, the seemingly invincible startup could be worth zero.
It’s naïve to assume that any company, public or private, is immune from a dramatic drop in value. But an investor holding 5% of its portfolio in Theranos equity would be far less nervous about their wealth than an investor with, say, 70% exposure. That same investor would also be far less likely to be scrambling to find the limited buyers willing to purchase the illiquid asset of Theranos equity. While the value of any company can go to zero, hedging yourself against that risk through portfolio rebalancing is imperative.
As the startup landscape evolves and companies specialize in new technologies, it will be important for investors to have accessible capital to deploy to new ventures. To obtain that capital, a private stock investor may have to sell an existing holding. A desire to invest in a new startup certainly should not be an indictment of another company. This is especially true if the startup that the investor is selling to generate capital has justifiably increased in value. If a large mutual fund sells a significant portion of a holding in a public stock that has doubled in value, the decision isn’t perceived as a denunciation on the value of the company. Instead, the fund is lauded by investors for locking in a profit. Similar praise should be given to private market investors.
The good news is that there are a variety of platforms through which investors can liquidate a portion of their private stock holdings. Private secondary market platforms such as EquityZen, connect shareholders of startup companies with investors looking for access to late-stage companies before IPO stage. Access to such platforms will continue to provide private market investors with the ability to sell their holdings to ensure that their portfolios are structured in a way that minimizes their risk.