Alternative investments are a major strategy within the Barton TVC portfolio. So what are “alternative investments” and why are they so important in world of investing?
According to prequin.com, the alternative investments are projected to reach $14 TRILLION in assets under management (AUM) in 2023 and are regarded as the fastest-growing class in finance. This class comprises any asset besides stocks, bonds, and cash.
Unlike traditional asset classes, alternative investments can’t be easily converted into cash and are usually unregulated by the SEC. They also often have a low correlation with other asset classes, particularly the public stock market which makes them excellent choices for portfolio diversification.
One type of alternative investment is private equity.
WHAT IS PRIVATE EQUITY?
Private equity (PE) represents capital investments made into private companies. These companies aren’t listed on a public exchange, such as the NYSE or NASDAQ and thus, investing in them is considered an “alternative”. The “equity” in these private company transactions is the investor’s stake in the private company and the value of those shares after all debt is repaid.
PE investment firms perform complex due diligence on private companies and purchase shares with the goal of creating a higher value by a specific date. PE investment firms raise capital through high net worth investors, family offices, institutional investors (think pension fund managers, mutual funds, insurance companies, etc.) The major players in this space are large investment banks like Morgan Stanley, JPMorgan, UBS, Merrill Lynch alongside recognized PE firms Blackstone, Neuberger Berman, Carlyle, KKR, etc.
PE firms also offer valuable senior leadership experience and industry knowledge as an important value-add. Typically, large investors will acquire board of director seats in exchange for the equity investment to assist in steering of the company’s growth and strategic direction. This can include bolt-on acquisitions and the addition of executive talent. The goal is to generate enterprise value (EV) growth so when the investment is sold (typically merger or acquisition by another private company or buyout by another PE or public entity), a substantial profit is earned - often substantially greater than that of other asset classes.
TYPES OF PRIVATE EQUITY STRATEGIES
Barton TVC invests across all three private equity strategies: venture capital, growth equity, and buyouts. Each of these strategies has unique characteristics that align with points along the timeline of private company’s life cycle.
1. Venture Capital
Venture capital (VC) is the highest risk form of private equity as these investments are made in an early-stage, startup businesses. There are hundreds of VC’s in the United States alone seeking to invest in start-up firms with the goal of obtaining an equity position in “the next great idea”. These companies can be “pre-revenue” meaning the company has no clients or sales or is still paving out an idea and lacks a service or production product". Some start-ups have a limited number of clients with a cash “burn rate” greater than the money it takes in from customers (not cash flow positive or profitable yet).
VC investments are very risky because startups haven’t yet proven their ability to turn a profit. A VC investment typically leaves the founders with a control of the company which is attractive to the management team. This investment is priced with the expectation of a heavy discount to future equity pricing rounds given the nature of the early gamble on the unproven firm by the VC investor. Many of these ventures fail resulting in a total loss of the investment for the VC investor. However, the upside is that enormous returns can occur when the next Microsoft or Amazon business is discovered. Venture capitalists have made billions in this manner.
2. Growth Equity
Growth equity is a capital investment in an established, growing company. This is where the Barton TVC invests the majority of its alternatives portfolio. Companies in this lifecycle need additional funding to expand the scale of the company’s revenue and are typically in. Series A/B/C funding round. These investments are largely minority stakes with expectations of an exit in the investment within 3-10 years (depending on the strategy followed by the PE firm for their investors).
Unlike venture opportunities, businesses seeking growth equity have much more data to analyze. This due diligence (DD) includes business plans, financial performance, customer and product performance, personnel and capital raise history. DD is somewhat of an art form: there are technical data points, objective and subjective performance measurements and broader market segment competitive analysis and even geo-political considerations. A disciplined investing thesis and thorough DD is critical in the selection process of investing in any prospective company.
Barton TVC, like many firms involved in growth equity investments, searches the marketplace for companies to invest in by subscribing to tools and maintaining a complex database of company candidates fitting our investment strategy. We track their financial information including investment partners/funding rounds which over time allows Barton TVC to identify companies with high growth and profit potential. We then either co-invest in partnership with larger PE firms (further spread the risk) or directly invest on our own.
Use of invested funds, projected return of capital (“ROC”) and Investment Rate of Return (“IRR”) heavily drive the decision to invest. PE investors require a documented growth strategy from the company to reasonably predict the ROC and IRR. Most companies seeking growth equity investment need to hire additional employees, expand office facilities or market presence, add sales and marketing or make infrastructure investments (technology) to meet increasing customer demand. Understanding the uses of the funding is another critical part of the due diligence process.
This PE investment occurs when a mature company - typically public - is taken private and is purchased by either a single or multiple private equity firms or by its existing management team. This is the segment represents the large dollars in terms of committed capital in the private equity space given deal sizes. These types of investments are a minor component of the Barton TVC portfolio and only purchased via a minority participation in an investment bank or PE firm fund.
When a buyout occurs, all of the company’s previous investors sell their shares to acquiring party. The PE private firm or management team becomes the sole investor and holds a controlling share (>50%) of the company.
There are two types of buyouts:
Management buyouts, in which the existing management team buys the company’s assets and takes the controlling share. This allows all investors and stakeholders to cash in on their shares before company management takes control. The management team may raise the funds necessary for a buyout through a private equity company, which would take a minority share in the company in exchange for funding. It can also be used as an exit strategy for business owners who wish to retire.
Leveraged buyouts (“LBO”), which are buyouts funded with borrowed money. Leveraged buyouts make sense for companies that wish to make major acquisitions without spending too much capital. The assets of both the acquiring and acquired companies are used as collateral for the loans to finance the buyout.
Buyouts are designed to shift control of the company for a period of internal improvement and for those improvements to provide a return on the investment it takes to buy out the company. Buyouts come with significant risk but can potentially allow a company to restructure and reset for strong growth.
Private equity, however, is just the tip of the alternative investments iceberg. Other types of alternatives that Barton TVC invests in include private debt, hedge funds and real estate. We will discuss these in future blog postings. Other forms of alternatives such as art/collectibles and commodities (think gold, energy, lumber, pork bellies, etc.) are not the target of the Barton TVC investment strategy at this time.