Changing dynamics in private markets

Private markets have evolved having an enormous expansion with huge value creation during the private phase of a company’s life. This has prompted an acceleration of activity in recent years with a significant shift in the dynamics of the capital formation process for companies.

Companies are now raising more equity funding within the private markets. On average a company goes through three equity funding rounds prior to going public compared to one a decade ago and raising close to twice as much capital. As a result, the valuation impact has been dramatic creating highly valued unicorns in which there are more than 300 in Europe, a high proportion having gained this status in the last couple of years versus only 11 in 2010.

A clear shift has been in the changing dynamics of the capital formation process companies go through as they grow

Shifts in the capital formation framework

There are a combination of dynamics resulting in the evolution of the private markets. A clear shift has been in the changing dynamics of the capital formation process companies go through as they grow. Historically this framework has had clear sources of capital at each stage of a company’s funding evolution. In their early stages, initial capital funding rounds come from venture capital firms and angel investors in Seed and Series A & B rounds. With time as the company enters the growth stage later-stage venture capital and growth equity funds typically provide funding for subsequent rounds of Series C and D and after. In some instances, as a final funding step prior to an IPO companies may also raise a ‘crossover’ round.

Given the macro environment where rates are incredibly low investors have moved up the risk curve towards assets that yield more. Equities have been one beneficiary and we have seen that in the public markets and one of the other features is in the private markets with investors moving earlier in the life cycle of companies.

Hedge funds participation in private markets

The migration of value creation in the private markets has shifted the dynamics between private and public markets. Hedge funds have demonstrated this with their growing participation of investing earlier in the life cycle of companies having typically been limited to the public markets. This structural change of the broadening of their investment universe has tended to focus on the late-stage companies within the capital formation framework immediately adjacent to public markets. The thesis is very simple, if public investors can get access to the those privately before they go public, there is a premium that they can be rewarded. Late-stage private companies are a fantastic way to play a growth theme which is evident in the volume of capital flowing into continuation and growth funds combined with venture capital and private equity.

Late-stage private companies are a fantastic way to play a growth theme

Growth in the private markets and the strong returns from venture capital and private equity has increased the interest from hedge funds, which has increased in recent years. In deal volumes hedge funds play a minority role however in terms of capital deployed they have a bigger footprint. Their larger participation in late-stage companies is reflected with more than three quarters of capital invested in Series C or later. In terms of geography there is a dominance of US companies and a in terms of sector there is a clear skew towards technology, media and telecom as well as healthcare.

Hedge fund and company perspectives

Aside from potentially higher returns there are other indirect benefits from the hedge fund perspective such as information synergies. As hedge funds position themselves across the private and public divide, they are able to have a much more holistic view given the higher level of disclosure from private companies which help inform public market investments and vice versa. So insights derived from one can help to inform the other.

Hedge funds can leverage their expertise & insights in the public market to companies interested in an IPO

There are certain unique advantages hedge funds can differentiate themselves within the competitive late-stage funding rounds from private equity and venture capital funds. From the company perspective an edge hedge funds have is they can leverage their expertise and insights in the public market to companies interested in an IPO. In addition, they can position themselves as long-term investors not requiring a board seat and capitalize on their name to bring credibility to an IPO process.