Investing in Unlisted Companies

There are many asset classes that are available to the common man. The average investor can put their money in stocks, bonds, real estate, gold, mutual funds, etc. However, there are certain asset classes which are not available to every individual.

One of the asset classes are “unlisted companies” or private equity. These asset classes tend to provide the best returns but also have the highest risk. This is the reason why in most parts of the world, the access to these investments is limited.

In the United States, for instance, only accredited investors are allowed to invest in this asset class. The Securities and Exchange Commission (SEC) has taken great care to define what they mean when they use the term accredited investors.

In this article, we will have a closer look at the investing strategies which are followed by these accredited investors when they invest in unlisted companies.

Layered Investment

Layered investment is one of the most frequently used strategies when it comes to investing in unlisted companies. Under this strategy, investors, i.e. limited partners allocate funds to fund managers, i.e. general partners. These general partners then allocate these funds a wide variety of private equity funds.

This means that the general partners do not make direct investments. Instead, they involve another layer of general partners who make investments on their behalf. The main advantage of this strategy is the increased diversification that it has to offer.

Instead, of focusing on a particular segment or company, investors can apportion their funds into multiple investments. Obviously, the chances of failure are drastically reduced.

Layered investments are also known as fund-of-fund investments. These investments are generally used by accredited investors who are new to unlisted investing. This model allows them to quickly scale up their portfolio without being worried about risk.

Layered investments are also common when newer geographical regions are being explored. The general partners want to include another layer of general partners because of the local expertise that they bring along.

Investing In Private Equity Funds

Instead of using a layered investment, accredited investors can also directly invest in the private equity funds. Under this investment structures, the limited partners partner with the general partners.

However, the general partners do not create any layer. Instead, they directly invest in certain companies. This is the most preferred mode of investment when it comes to investing in unlisted companies.

The limited partners tend to have very little knowledge about the underlying companies that the funds are being invested in. Instead, they invest based on the past track record of the fund managers.

Simply put, the reputation of the fund manager is of paramount importance to the fund. This is the reason why fund managers in private equity tend to be well compensated. Another advantage of investing using the private equity model is that it is cheaper as compared to the layered structure.

Since one layer of intermediaries is reduced, the cost is reduced by an average of two percentage points! The main drawback of this system is that the limited partners are supposed to directly select the fund that they want to invest in.

In order to take this decision correctly, they must know how to select a fund manager. Also, these funds tend to be relatively illiquid. The investments made are for a fixed duration of time and cannot be recouped before the time period is up.

Direct Funding

Sometimes, limited partners, i.e. investors just tend to bypass the entire routine of finding general partners. In some cases, they directly make investments into unlisted companies without having any intermediaries. Since there are no general partners, there are no fees associated with them too.

However, still, it would be wrong to say that this cost structure is more cost efficient than alternate arrangements. This is because the limited partners are responsible for the entire deal cycle.

This means they are the ones that have to source the right deals, have to do the right due diligence, conduct the valuation and be aware of the possible exit strategies before making the investment. This is one of the riskiest ways of investing in unlisted companies. This is because there are practically no regulations regarding how unlisted companies can and must operate.

Hence, it would be right to say that the investors are pretty much on their own. This is why expert help is needed, and in the absence of this expert help, investors are more likely to make mistakes.

However, many limited partners have been particularly successful while using this model. They have built their own teams of talented individuals who perform the tasks that general partners do for a much smaller remuneration.

This method is preferred by many because it provides more control over the investments. Despite its advantages, direct investing is still a pretty recent phenomenon. The advantages and disadvantages of direct investing are yet to be empirically analyzed.

To sum it up, unlisted equities is a very good asset class. It has provided great returns which beat the general market on more occasions. However, the method of investing in private equities must be carefully selected after due diligence.