Unicorns, Donkeys, and Late Stage Valuations - Are You Managing Your Portfolio Well? (Part 2)
Dec 17th, 2015
Remember Bob and Susan who walked into a bar? This article is part two of a two-part series on investing in growth technology given concerns over late stage valuations. Click here for part one.
Bob and Susan are still at the bar…
Private Secondary Market
Bob: “Aren’t private investments illiquid? How can you rebalance them?”
Susan: “Liquidity is a sliding scale. Google stock is liquid. Your late stage investment is less liquid. Your broken VCR is illiquid.”
Less liquid is not the same as illiquid. Many private market investors may not realize there are active secondary markets that could help them move into and out of investments with the company’s blessing. Secondary markets are a venue where investors can sell some of their investment, just like they can with their Facebook stock through Schwab, with the added step of getting the underlying company’s permission. Of course, as Susan points out, liquidity is a sliding scale, with private investments being less liquid than the public ones.
Just as with public markets, if you have seen investment appreciation that meets your target IRR, it might make sense to sell a portion of holdings in a given name to lock in a target return5. Rather than continuing to leave the investment capital and gains at risk, investors might consider re-deploying it into a different company. Here at EquityZen, we see savvy shareholders (employees and early investors) diversify themselves by selling some of their holdings and deploying the cash into other investments6.
Bob: “Why isn’t everyone doing this?”
Susan: “More do it than you think. Private markets have only recently begun to mature rapidly. Don’t overthink it.”
There is currently, an irrational avoidance of portfolio rebalancing, primarily driven by two factors. First, as discussed above, many new investors are simply not aware of avenues to rebalance. Secondly, there is a misconception that selling private stock is equivalent to loss of confidence in the investment. That argument is like assuming the only reason Bob would sell his AMZN shares is because he believes the investment will tank. Couldn’t Bob have also hit his target return and wanted to sell some of his holdings? Couldn’t Bob simply see a better investment opportunity? Couldn’t Bob simply need cash to buy a new house?
As traditional modern portfolio management theory suggests, diversification is crucial. Benefits from diversification can be derived by diversifying across sub-sectors (e.g. hardware, Internet of things, cloud, etc.) as well as across stages of the company (pre-seed and seed, Series A-C, growth equity, etc.).
Private market investments are highly risky and therefore deserve a small, but non-zero portion of the total portfolio’s allocation. It is easy to see there is a big difference between a company that has been in existence for 3 months, one that has raised $30M in VC financing, and one that generates $30M of annual revenue. There is a place in Bob’s portfolio for each of them. It is a little harder to see that if there is uncertainty about the market cycle, the relatively safer investment is in the company that generates $30M in revenue7. Given uncertainty in the market, should Bob keep investing in 3 month-old businesses, or take some of that capital and put in in a business generating tens of millions in revenue?
Since venture capital industry have had a consistent shortlist of top-decile performing money-managers, tracking portfolios of these proven VCs is another strategy that private investors find fruitful. As discussed in part one of this series, getting access to those investments (that is, getting into the exclusive country club) used to be nearly impossible, but can now be performed online. Simply Google search “invest in [your desired company]” to see what options you have available to invest on the secondary market.
Warren Buffett famously said “if you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.” No one is suggesting Bob attempt to trade private investments every six months or even every couple of years. But, from time to time, even Warren Buffett is rumored to have rebalanced his portfolio and re-invest.
This article is part two of a two-part series on investing in growth technology given concerns over late stage valuations. Click here for part one.
Disclaimer: This article does not a) constitute investment, financial, or tax advice, b) intend to purport an offer to engage into a securities or similar transaction, nor c) reflect the views of EquityZen. It represents simply my personal opinion.
3: Since these high reward investments, obviously come with high risks, only accredited investors are qualified to invest. Take a qualification test here to see whether you qualify as an accredited investor
5: See Locking-in Profits strategy