IRR, or the Internal Rate of Return, is the gold standard for measuring fund performance.
In a nutshell, IRR is the annualized and dollar-weighted return that a fund generates on all of its investments. In contrast, a time-weighted return simply tallies up a fund’s total return over a given period without considering the amount of capital invested at different points in time.
As mentioned, IRR is a dollar-weighted return, which considers the timing of cash flows in and out of a fund. This is important because it gives a more accurate picture of the fund’s performance rather than just looking at the total return over a given period.
Since an absolute return doesn’t normalize to an annual figure, it can be misleading. You need to annualize both returns to compare two funds with different investment horizons.
The easiest way to calculate IRR is with a financial calculator or spreadsheet software. You can also estimate IRR by using the following formula:
IRR = (Ending Value / Beginning Value)^(1/n) – 1
where n is the number of years in the investment period.
For example, you invested $10,000 in a fund five years ago, now worth $15,000. The time-weighted return would simply be (15,000 / 10,000) – 1 = 0.5, or 50%.
To calculate the IRR of this same investment, we would plug the numbers into the formula above:
IRR = (15,000 / 10,000)^(1/5) – 1 = 8.4%
This lets us compare the performance of this fund to other investments since we’re now dealing with annualized returns.
While IRR is a helpful metric, it does have its limitations. It’s important to remember that IRR is a backward-looking measure. That is, it only tells you how a fund has performed in the past, not how it will perform in the future.
Second, IRR can be manipulated. Consider capital calls or demands for payment of the committed but uninvested portion of a fund’s capital. Suppose a fund manager does not call significant amounts of capital during a year in which the fund has strong performance. In that case, the denominator in the IRR equation will be artificially low, leading to a higher calculated IRR.
Finally, two investments with the same IRR won’t necessarily generate the same return on capital. This is because IRR doesn’t consider an investment’s effective hold period. For example, a fund that generates a 20% IRR over seven years will have a different return on capital than a fund that generates the same 20% IRR over ten years.
Despite these limitations, IRR remains a crucial measure for assessing fund performance. You can use IRR to make more informed investment decisions by understanding how it works and its limitations.
Return multiples are another popular metric for measuring fund performance. Different multiples calculations use different numerators (realizing, unrealized, or total proceeds) and denominators (referring to the amount of capital invested, committed, or called).
The TVPI, or Total Value to Paid-in Capital, measures the value of the realized and unrealized investment. In comparison, DPI, or Distributions to Paid-in Capital, only includes realized proceeds distributions. In contrast, the Residual Value to Paid-in Capital (RVPI) includes unrealized proceeds. Each of these three return multiples can provide different insights into how a fund performs.
If you’re looking to measure fund performance, IRR is the metric. It’s a dollar-weighted return that considers the timing of cash flows, and it can be easily annualized to compare different investments. Remember that IRR is a backward-looking metric, and capital calls can manipulate it.
Adverse selection occurs in any market where one party has more information about the quality of a good or service than the other party. In the context of investment platforms, adverse selection can result in lower-quality projects being funded, resulting in lower returns for investors.
Startup investor Julian Shapiro has written about this problem, saying, “the enemy of returns in venture is adverse selection.” The same issue can occur on investment platforms that act as marketing or placement agents for funds, as some platforms are compensated for the placement of funds on their platform, which could have negative implications for fund quality.
Further, investment platforms that act as “funding of last resort” can also create a downward spiral of adverse selection. When companies turn to these platforms, it can signal that the company is not able to raise money from more traditional sources.
In another example, research from HBS found that “co-investments underperform the corresponding funds with which they co-invest due to an apparent adverse selection of transactions available to these investors.”
To mitigate the problem of adverse selection on investment platforms, it is crucial to consider the following:
By considering these factors, platforms can work to mitigate the problem of adverse selection and ensure that only high-quality investments are being offered.
Gridline takes a proactive approach to mitigating adverse selection on its platform. The company is focused on top-quartile, professionally managed funds and has a rigorous manager selection process. Gridline also ensures that its compensation structure does not incentivize lower-quality projects.
Gridline’s investment team has over 20 years of experience running private market portfolios for top endowments and family offices. One member was the CIO of a $13 billion family office, while the other ran UTIMCO (one of the largest endowments in the US). This experience has given them a deep understanding of the private markets and how to identify high-quality managers and projects.
Gridline begins its manager selection process with a comprehensive market analysis, drawing on various sources, including third-party data providers, contacts within the Investment Manager’s network of fund managers, and other limited partners. This analysis is used to identify funds deemed worthy of further consideration based on a set of quantitative screening tools.
The screening tools review past performance and compare it to a customized peer group of funds with similar investment styles (e.g., sector, stage, strategy). This allows Gridline to better understand the strategy’s risks, the consistency of management’s investment approach, and whether outperformance may be sustainable over a long time horizon.
Once a fund has been identified as worthy of further consideration, Gridline engages with the manager to better understand the fund’s strategy and investment thesis. This process allows Gridline to select managers that it believes display preferential access to investments (e.g., strong sourcing & networks), exhibit superior portfolio management skills (i.e., through exit), have a strong track record of success, anticipate market movements, and have a deep conviction in their thesis & strategy to “deliver alpha.”
By taking this proactive and thoughtful approach to manager selection, Gridline can mitigate the problem of adverse selection and ensure that its investors have access to high-quality investment opportunities.
The notion that cryptocurrency is a safe-haven asset has long been touted by its proponents. The idea of Bitcoin as a “digital gold” that can protect investors during economic turmoil has been a popular narrative. While it’s true that actual gold has historically been a haven asset during times of recession, data indicates that Bitcoin is anything but.
The COVID-19 market crash put this fact in stark relief. As the S&P500 crashed, Bitcoin fell in lock-step. If we look at more recent data, we can see that Bitcoin has not been a haven asset during the current turmoil. The S&P500 has had its worst first half in 50 years. During that same time, cryptocurrencies are down by $2 trillion.
Fortunately, some assets offer low-to-negative correlations with the stock market, making them relatively safe havens, including private equity and venture capital.
Rampant inflation, interest rate hikes, low consumer confidence, ongoing supply disruptions, and general economic malaise are the ingredients of a recession.
It’s no wonder that economists from Deutsche Bank to JP Morgan have been warning for months that a recession is on the horizon. Bringing layoffs, reduced consumer spending, and business closures, a recessionary environment is an antithesis of what most companies need to thrive.
In this environment, private markets have, historically, been a haven. A Neuberger Berman Group study highlights that private equity funds fared better than public markets during the dot-com bubble of the early 2000s and the Great Financial Crisis (GFC) of 2007-2009, with a less significant drawdown and a quicker recovery. In past recessions, only 2.8% of buyout funds experienced catastrophic loss, compared to 40% of stocks.
Private market outperformance isn’t limited to just downturns, either. In the decade following the dot-com crash, the public market equivalent index’s annual return was a measly 0.08%, while private equity yielded a robust 7.5% average.
Several factors combine to make private companies less exposed to economic downturns than their publicly-traded counterparts.
Private companies tend to have longer time horizons than publicly-traded companies. They’re not beholden to quarterly earnings reports and the short-term thinking that comes with them. This enables them to make the long-term bets that are often necessary to weather an economic storm.
Further, private companies are often more nimble than public companies. They can make decisions quickly and without the need to obtain shareholder approval. This allows them to take advantage of opportunities that might arise in a recessionary environment.
In addition, private companies are not as dependent on the health of the overall stock market for their funding. Venture capitalists continue investing heavily in startups, despite the current economic turmoil.
So, private markets are an attractive bet if you’re looking for a haven during a recession. Even smaller investors are entering private markets, which have been made more accessible with alternative investment platforms like Gridline. Gridline provides access to a curated selection of professionally managed alternative investment funds with lower capital minimums.
That said, private equity and venture capital aren’t the only assets with a low correlation to the stock market. Real estate can also provide a measure of safety during economic turmoil. This is particularly true now, as a period of consistently high inflation is driving up rent, and thus cash flow, for landlords.
The bottom line is that there are several potential safe havens, from private equity and venture capital to real estate, but cryptocurrency fails to make the cut. If you’re looking to protect your portfolio during a recession, these are the assets you should look at.
An individual retirement account (IRA) is a savings plan that offers specific tax advantages to help you save for retirement. There are several different types of IRAs, including traditional IRAs, Roth IRAs, spousal IRAs, SEP IRAs, SIMPLE IRAs, non-deductible IRAs, and self-directed IRAs.
The main benefit of an IRA is that it allows you to save for retirement on a tax-deferred basis. That means you won’t have to pay taxes on the money you contribute to your IRA until you withdraw it during retirement. This can help you save more for retirement because your money will grow faster than if it were subject to taxation yearly.
Traditionally, IRAs have been invested in stocks, bonds, and mutual funds. However, recent changes in the law now allow for alternative investments such as real estate, private equity, and hedge funds to be held in an IRA. This is a significant change because it opens up a new world of investment opportunities for retirement savers.
The most common type of IRA is the traditional IRA. With a traditional IRA, you can make tax-deductible contributions, and your money will grow tax-deferred until you retire. When you withdraw money from a traditional IRA in retirement, you will pay taxes on the withdrawals.
The second most common type of IRA is the Roth IRA. With a Roth IRA, you make contributions with after-tax dollars (meaning you’ve already paid taxes on the money you’re contributing). This means that when you withdraw money in retirement, you won’t have to pay any taxes. You may have heard of the term “backdoor IRA,” which describes the process of contributing to a Roth IRA when your income exceeds the Roth contribution limits.
Self-directed IRAs are a type of IRA (a traditional or Roth IRA) that gives investors more control over their investments. With a self-directed IRA, you can invest in alternative investments such as real estate, private equity, and hedge funds.
Investors typically seek out alternatives for portfolio diversification and the potential for higher returns. For instance, private markets have consistently outperformed public markets over the long term.
However, all capital gains are subject to taxation. This can eat your returns, especially if you’re in a high tax bracket.
One way to avoid this is to invest in alternatives through an IRA. With an IRA, you can invest in alternatives on a tax-deferred basis. That means you won’t have to pay taxes on the capital gains until you retire and start withdrawing money from the account.
This can be a significant advantage because it allows your money to grow faster than it would if it were subject to annual taxation.
IRAs and alternative investments are a natural pair because they’re both long-term investments. That means you won’t need to access the money in your IRA for many years, allowing you to take on more risk in pursuit of higher returns.
One downside of IRAs is that they have contribution limits. For 2021 and 2022, the contribution limit for traditional and Roth IRAs is $6,000 (or $7,000 if you’re 50 or older).
This can limit high-income earners who want to save more than the contribution limit allows. In this case, you may consider investing in alternatives outside of an IRA.
Another downside of IRAs is that they have required minimum distributions (RMDs). RMDs are the minimum amount you’re required to withdraw from your IRA each year once you reach age 70 1/2. The purpose of RMDs is to ensure that people don’t use their IRAs as tax-deferred savings account for their entire lives.
However, RMDs can burden investors who don’t need the money and would prefer to keep the money invested.
Another downside of IRAs is that they have estate taxes. When you die, your IRA will be included in your taxable estate. Your beneficiaries will have to pay taxes on the distributions they receive from the IRA.
401(k)s are employer-sponsored retirement plans. That means your employer offers the plan, and you make contributions through payroll deductions. 401(k)s have higher contribution limits than IRAs (up to $20,500 for workers under 50 in 2022). They also typically offer employer-matching contributions, which can be a significant advantage.
However, 401(k)s are subject to RMDs just like IRAs. And, if you leave your job before you reach age 59 1/2, you’ll likely have to pay a 10% early withdrawal penalty on the money you withdraw from your 401(k).
The main difference between IRAs and 403(b)s is that 403(b)s are employer-sponsored retirement plans for public schools and non-profit organizations’ employees. Other than that, they work the same as 401(k)s. Another type of employer-sponsored retirement plan is the 457(b) plan. 457(b) plans are for state and local government employees (and some non-profit employees).
Annuities are a type of insurance product used for retirement planning. With an annuity, you make one lump-sum payment (or a series of payments), and the insurer agrees to make periodic payments to you for a specified period (typically during retirement).
There are two main types of annuities: fixed annuities and variable annuities. Fixed annuities guarantee a fixed rate of return, while variable annuities offer the potential for higher returns but also come with more risk.
The most significant advantage of an annuity is that it offers a guaranteed income stream in retirement. That can be a valuable benefit, especially if you’re worried about outliving your savings.
The downside of annuities is that they’re often complex products with high fees. They also typically have surrender charges, which means you’ll pay the penalty if you withdraw your money before the specified period.
Alternative investors seek long-term capital appreciation and higher return potential through investments such as private equity, real estate, and hedge funds.
While these types of investments are subject to taxation, one way to defer taxes is by investing in them through an IRA. With an IRA, you can make tax-deferred contributions, and your money will grow tax-deferred until you retire. When you withdraw money in retirement, you’ll pay taxes on the withdrawals but not on the money that has grown in the account.
With Gridline, you can quickly and efficiently gain exposure to top-quartile private market alternative investments in your IRA. Gridline’s mission is to open up access to these investments, which have historically been available only to sophisticated family offices and endowments, allowing individuals to invest transparently, efficiently, and at a lower cost.
The goal of retirement investing is to preserve and grow your wealth to maintain your lifestyle in retirement. Since public markets are struck by recessions every six years, on average, investors need to diversify their portfolios to reduce risk.
Risks are associated with over-concentrating your portfolio on any asset class, sector, or region. Doing so exposes you to greater market volatility and the potential for more considerable losses.
For example, during the COVID-19 market crash, Canada’s ten most significant pension funds lost an estimated $104 billion due to an over-concentration in public equities. Individuals nearing retirement age are especially vulnerable to such losses, as they have less time to recoup their losses.
Investing in alternative assets, like private equity and hedge funds, can help diversify your portfolio and protect you from the ups and downs of the stock market. IRAs, or individual retirement accounts, are investment accounts that offer tax benefits to encourage savings for retirement. Investing in alternatives through an IRA is a powerful way to grow your wealth while taking advantage of the tax benefits.
Investors and investment advisors alike face significant risks when over-concentrating a portfolio.
Investment advisors have a fiduciary duty to their clients, which includes the duty to diversify. As the law firm Lubiner, Schmidt & Palumbo explains, “an allegation of overconcentration against a broker connects to Suitability and FINRA Rule 2111, and is considered a violation of the rule, as well as a breach of a broker’s fiduciary duty.”
These aren’t just empty words: the NYSE found that one representative “recommended and effected unsuitable transactions that resulted in high concentrations of technology sector unit investment trusts,” resulting in a censure and a 10-year suspension.
Over-concentration can pose a significant risk to an investor’s financial security. Financial adviser Hannah Szarszewski warns, “what I see regularly is an over-concentration in the technology sector.” While the tech industry led the charge after the pandemic, it has since suffered catastrophic losses, even with a recent bull run. For instance, the ARKK innovation ETF is still down over 60% from its all-time highs.
One way to diversify your retirement portfolio is to invest in alternative assets through an IRA.
An IRA allows you to contribute to an investment plan pre-tax, up to a certain amount each year. Traditionally, IRAs have been invested in stocks, bonds, and mutual funds. However, the IRS now permits a broader range of investments, including cryptocurrencies, hedge funds, and private equity.
Diversifying with alternatives is a good strategy in any market condition, but it is crucial during periods of market volatility. For instance, during both the dot-com crash of 2000 and the global financial crisis of 2008, private equity funds had a less significant drawdown and quicker recovery than public markets. Further, while 40% of stocks experienced catastrophic loss in a recession, only 2.8% of buyout funds did.
Considering that current retirees have experienced 5-10+ recessions over their adult lifetime, it’s clear that diversifying your portfolio with alternatives is a smart move. The lifetime benefits of an alternative investment strategy are apparent when compared to the potential losses from an over-concentrated portfolio.
Not only that, but the outperformance of private markets extends beyond just recessions. For example, in the ten years following the dot-com crash, private equity maintained a 7.5% average, compared to just 0.08% for the PME index.
More recently, private equity has again outperformed public markets. A study by Hamilton Lane shows that since 2017, private equity funds have generated an extra 83 cents per dollar invested.
Millennials today are incredibly forward-thinking when it comes to their finances. Nearly 90% of them have some retirement plan, compared to just 73% of baby boomers at their age. They’re also putting away around twice as much as boomers.
Young people also know that traditional investments make “dismal” returns, and nearly 75% of millennials plan to use an alternative investment approach in the next five years.
Even Gen Z is getting in on the action: a poll of 2,000 UK investors found that 62% of Gen Zers have invested in alternatives. In less than a decade, Gen Z incomes are expected to surpass millennials, making them an increasingly important demographic for the industry.
That said, older investors shouldn’t feel left out. Many boomers already invest in alternatives, and 60% of those over 65 want mainstream crypto adoption. Boomers also dominate real estate: They have owned the most non-commercial real estate since 2001.
IRAs offer a great way to diversify your portfolio with alternative assets. With the tax benefits, they provide a powerful tool for retirement planning. For the next generation of retirement investors, investing in alternatives through an IRA is a smart move.
While private markets have outperformed public markets, an institutional-grade investment strategy is still essential. One key reason is that private markets have a much larger dispersion of returns, so selecting the wrong manager could cause significant underperformance.
For individuals, one of the best ways to access private markets is through a fund of funds, which invests in various VC funds to reduce risk. This strategy provides the diversification individuals need to reduce risk while providing the potential for solid returns. As an NBER study showed, VC fund of funds, too, consistently outperform the S&P 500 and Russell 2000 PMEs.
Diversified private market portfolios outperform public markets and can achieve return dispersion, a measure of risk similar to traditional investment portfolios.
Regardless of the funds selected, a long-term investment horizon is crucial. This is true in public markets and even more so in private markets, where there is often a lack of liquidity. In addition, investment funds often follow a “J-curve,” meaning that returns may be harmful in the early years and then improve as the fund matures.
Accessing private market opportunities, however, can be difficult for individuals. For one, minimum committed investment amounts can reach $25 million or more. Further, the number of investors in a fund is often constrained to between 10 and 20. And, of course, due diligence is time-consuming and resource-intensive.
Gridline solves these problems by providing a curated selection of professionally managed alternative investment funds and enabling access for individual investors and their advisors to gain diversified exposure to non-public assets with lower capital minimums, lower fees, and greater liquidity.
Gridline is the Vanguard of alts, making diversified investing in private markets as easy as investing in an index fund. For retirement investors looking to diversify their portfolios, Gridline is the solution.
Fidelity Investments recently announced the launch of two new liquid alt funds, Fidelity Advisor Macro Opportunities Fund ($FAQFX) and Fidelity Advisor Risk Parity Fund ($FAPZX).
Liquid alts saw record inflows in 2021, totaling over $38 billion. Fidelity’s new funds are just the latest in a string of offerings from asset managers looking to get in on the action. This year through May, liquid alts have seen over $21 billion in inflows.
But what exactly are liquid alts, and how do they differ from their illiquid counterparts?
Liquid alts are mutual funds or ETFs that provide diversification and downside protection through exposure to alternative investments. Unlike traditional alts, which can only be bought and sold on specific dates or after a holding period, liquid alts can be bought and sold daily. This makes them much more accessible to retail investors, who often can’t meet the large minimum investment requirements, or the accredited investor status needed to invest in traditional alts.
Private equity funds, for instance, often come with $25 million minimum investment requirements and 10-year holding periods. Investors also must be accredited, meaning they have a net worth of $1 million or an annual income of $200,000. By contrast, liquid alt funds often have no purchase minimums, retail share classes, and daily liquidity.
Liquid alts addressed some of the criticisms of traditional hedge funds, namely high fees and a lack of liquidity, while providing diversification and upside potential. Retail investors seek alternative investments as we enter a low-yield environment with rising interest rates and sky-high inflation fears.
Liquid alts, however, are no panacea. For one, there is the risk that a liquid alt fund will not be able to replicate the performance of its illiquid counterpart. This is because, by definition, liquid alts are less invested in actual alternative assets and more exposed to public markets.
The illiquidity of hedge funds also protects redemptions, as investors can only pull their money out on specific dates or after a holding period. This is not the case with liquid alts, which can be redeemed daily. Selling pressure from redemptions can lead to forced selling and fire-sale prices, leading to lower returns for investors.
Some funds in the liquid alts category are down 10% yearly, and retail investors aren’t known for their patience. They tend to chase performance and quickly pull the plug when things go south. This can lead to even more volatility for liquid alt funds.
Liquid alts funds come in various flavors, with strategies designed to provide diversification and downside protection. Some popular strategies include long-short equity, nontraditional bonds, market neutral, managed futures, multi-alternative, bear-market, and multi-currency.
Equity market-neutral funds, like the AGFiQ US Market Neutral Anti-Beta Fund ($BTAL), seek to provide exposure to the equity market while hedging out the beta or market risk. The fund does this by taking long positions in stocks that are expected to outperform the market, such as H&R Block, and short positions in stocks that are expected to underperform, such as Block and Upwork.
Fidelity’s new Advisor Macro Opportunities Fund is an active management fund that can go long or short, aiming to achieve returns through skill and active allocation.
Investors should understand that liquid alts are not a silver bullet. They come with risks and challenges, but they can be helpful for diversification and downside protection. Investors should carefully evaluate the fund’s strategy, fees, and performance when considering a liquid alt fund.
Both the dot-com bust of 2000 and the subprime mortgage crisis of 2007-2009 were watershed events. In each case, a long bull market ended abruptly, asset values plunged, and widespread panic set in. While M&A activity naturally slows during a recession, some companies see opportunity where others see only trouble. Deals done during downturns can create large amounts of value.
A PwC analysis of public market returns found that firms that announced acquisitions during an economic crisis delivered over 7% higher returns than the relevant S&P 1500 sector average in the following 12 months.
A Harvard Business Review article confirms this finding: In a study of the 2008 Fortune 1,000 list, the TSR (Total Shareholder Return) of those that had made active acquisitions grew at an average of 16.9% over 5 years, compared to just 4.9% for other companies.
Of course, not all M&A deals are created equal. Value creation depends on the quality of the assets being acquired, the strategic rationale for the deal, and how well it is executed. But for companies with strong management teams and a disciplined approach to M&A, a downturn can be an opportunity to position themselves for long-term growth.
Whether or not we consider acquisition-related growth, private markets have outperformed in recessions.
In both the dot-com bubble and the Great Recession, private equity funds had a less significant drawdown and a quicker recovery than the stock market. In the decade following the dot-com crash, private equity returned a solid 7.5% average, compared to just 0.08% for the PME index.
Adding to this, only 2.8% of buyout funds experienced catastrophic loss during recessions, compared to a tremendous 40% of stocks.
Clearly, public markets aren’t a safe place to be during an economic downturn. Bonds, too, lack the returns even to match white-hot inflation. Cash, of course, rapidly loses value. This is where private markets can fill the void.
In sideways or bull markets, private markets also outperform. A Cliffwater analysis of PE investments in a 16-year period, including two bear and two bull markets, shows that PE outperformed public equities by 440 basis points yearly. It’s no wonder, then, that 90% of LPs expect private equity to continue outperforming public markets, according to McKinsey.
This outperformance has become even more pronounced in recent years. Since 2017, private equity funds generated an extra 83 cents per dollar invested, according to a study by Hamilton Lane. Private markets also show resilience in this year’s downturn, with median post-money valuation still rising across most stages.
As the analyses above shows, private markets already offer better risk-adjusted returns than public markets. But M&A can help private companies drive even more value.
Fundamentally, an acquisition is an investment. The acquirer seeks to generate a return on investment by growing the combined business. An acquisition can also serve other strategic objectives, such as entering new markets, adding new products or technologies, or increasing market share.
When done well, an acquisition can be a powerful engine of growth. Private market investors will benefit from several macro trends that are tailwinds for M&A activity. For example, supply chain disruptions are causing businesses to reconsider their reliance on just-in-time, single-source providers, and some are seeking transportation fulfillment acquisitions.
So-called “disruptive M&A,” or non-tech buyers acquiring tech companies, is another major trend. This has been driven by the belief that digitization is pivotal to success in nearly every industry. McKinsey research shows that digital entrants have rapidly seized 47% of digital revenue across regions and sectors. Finally, a $3.4 trillion dry powder war chest is another reason to expect strong M&A activity in the coming years.
These trends are coming to a head just as private market valuations are becoming more attractive, presenting an opportunity for private companies to buy assets at a discount.
M&As tend to ebb and flow with the stock market. But there’s one sector that has, so far, been surprisingly immune to this pattern: technology.
Despite the recent bear market, tech M&A activity is still going strong. As Fortune reports, tech M&A in 2022 is up 58% year over year, to $272 billion. From Broadcom’s $61 billion purchase of VMware to Microsoft’s $69 billion Blizzard acquisition, several big-ticket items have already gone through.
The reasons for this are front and center: first, this recession is likely to be short and shallow; second, businesses have over $3 trillion in dry powder; and third, as we’ve highlighted, downturn-era M&A can create significant value.
With so much capital sloshing around, it’s no surprise that valuations are high, and competitive bidding drives up prices. In this environment, M&A is often the best way to snag top talent, technology, and market share. Private market investors should note that downturns may be painful, but they ultimately create opportunities for those who are prepared to take advantage of them.
While private markets and M&A activity can create significant value for investors, an institutional-grade approach is needed to take advantage of these opportunities even in downturns.
This begins with creating a diversified portfolio that can weather various market conditions. Without a diverse set of investments, a downturn in any one sector, geography, vintage year, or asset class can decimate a portfolio.
With adequate diversification, it’s possible to achieve dispersion of returns similar to that of public markets. In other words, VC returns are far more predictable and dependable when a thoughtful and structured approach to portfolio construction is employed.
Institutional-grade due diligence on each fund is another critical piece of the puzzle. This includes a review of the fund’s team, performance, philosophy, investment process, and intangible factors such as perspective and passion.
Moreover, a long-term mindset is essential. Historic VC returns show that the bulk of the value is created in a fund’s later years in a J-curve phenomenon.
Executing this institutional approach, however, is easier said than done. Many private equity funds come with a $25 million minimum, and a diversified portfolio requires investing in several funds. For most individuals, this simply isn’t possible. High fees exacerbate the issue, as they can quickly eat into returns.
Beyond investment minimums, fund access is often limited based on personal relationships or other factors. This is why working with a platform like Gridline is essential. We provide access to a curated selection of top-tier private equity and venture capital funds so that you can build a diversified portfolio with lower minimums. We also charge lower fees so that you can keep more of your returns.
With Gridline, you can get the institutional-grade approach to investing in private markets that you need to drive value in any market condition.
There are almost 30% fewer publicly listed companies today than at the start of the millennium due to rising private-equity buyouts and strategic acquisitions. 2009 saw $118 billion of global buyout deal value, while 2021 saw over $1.1 trillion in deal value.
In addition, many firms are choosing to avoid the public markets altogether. As McKinsey writes, “recent surge aside, the number of IPOs did decline between 2001 and 2010,” which is particularly true among small deals. At the same time, companies that go public are delaying doing so for longer. The economic downturn is catalyzing this shift.
Even well-run companies can see their stock prices plummet in a volatile stock market. This is especially true in a recession when firms cut costs and reduce investments.
Therefore, going public in a recession “may be a kiss of death,” as described in a Wharton Magazine article. Why? Because correctly pricing an IPO is difficult enough in good times and near-impossible in bad times.
It’s no wonder that US IPOs worldwide fell a precipitous 82.5% year-over-year in the second quarter of 2022. Rather than risk it, many companies are sticking to private markets—where they can raise money without the same level of public scrutiny.
The shift to private markets has already been long underway, but the current economic conditions are accelerating. This is bad news for public markets and good news for private investors.
Naturally, VC activity, too, has dropped in recent months. But private market investors don’t just sit on the sidelines during economic downturns—they actively seek opportunities. In contrast to public markets, which are driven by short-term thinking, private markets take a longer-term view.
This was borne out in the dot-com bubble and the Great Recession, with private equity funds experiencing less significant drawdowns and faster recoveries than public markets. In the decade following the dot-com crash, the public market equivalent index’s annual return fell to 0.08%, while private equity maintained a 7.5% average.
Recent data suggest that this recession will be no different. CBInsights’ latest State of Venture report analyzed Q2 2022 startup data, finding that “median post-money valuation is on the rise across most stages.”
All median valuations from seed to Series D are up compared to 2020. This is due, in part, to an influx of “dry powder”—undeployed capital that investors are waiting to invest. Another reason is that, as IPOs have dried up, late-stage VCs are filling the gap by investing in private companies.
Only Series E+ companies have seen a dip in median valuation due to their closer proximity to public markets. That dip, too, has been modest, falling from $2.1 billion to $2 billion in 2022 YTD.
Investors today are leaving public markets in droves. JPMorgan reports that retail investors have capitulated. For institutional investors, however, the public market exodus is nothing new.
Institutions have been pouring money into private markets for years, only accelerating their pace. In a recent survey by Preqin, 81% of investors said they planned to increase their allocation to alternatives by 2025. Just 3% said they planned to decrease it.
The writing is on the wall: investors are losing faith in public markets and turning to private ones. For them, it’s simply a better way to preserve and grow their wealth. You must be in the private markets to take advantage of these trends. And Gridline is here to help with high-quality, professionally managed funds at minimums that let investors and their advisors build diversified portfolios of private market assets.
The war in Ukraine, China’s unending zero-Covid policy, and the global practice of unprecedented quantitative easing led to consistently high inflation rates, forcing The Fed’s hand to hike interest rates sooner than later. This has put pressure on public market returns, which were predicted to have “dismal returns” even before the crisis, as reported by The Economist.
In response, investors are increasingly turning to private markets, which historically have been more resilient to public market volatility, have provided higher absolute returns, and have been less correlated to the stock market. The vast majority of this capital is going to larger, more established private equity and venture capital funds. In fact, according to PitchBook data, of the total capital being raised, only 1.4% of it is going to smaller funds.
This is a mistake. Smaller funds have several inherent advantages that make them more attractive investments, borne out in their returns.
Research published by the American Economic Association highlights that fund returns decline with size. This is due to the diseconomies of scale in the money management industry, where larger funds are burdened by communication and hierarchy costs, management fees, and a lack of cohesion. In contrast, smaller funds have nimbler investment strategies, less bureaucracy, and better alignment between managers and investors.
This study isn’t an outlier. A paper from Singapore Management University found that, on average, smaller funds outperformed larger funds by 3.65% per year. Another examination by PerTrac found that, over 14 years, the cumulative total return for small funds was 576.91%, compared to 317.74% for large funds.
Performance suffers significantly with particularly large funds. For one, they are forced to make more simultaneous investments, diluting focus. Worse, these large funds cannot quickly exit, redeploy capital, find strategic buyers, or invest in new growth opportunities. An Invesco study shows that the average IRR for funds under $400 million was 19 to 20%, compared to funds of $400 million to $1 billion with an IRR of 7.2% and funds above $1 billion with an IRR of 2.4%.
These are dramatic performance differences that any serious investor cannot ignore. Not only do smaller funds outperform, but so do newer and first-time funds. In a comprehensive analysis of PitchBook data, researchers found that almost 18% of first-time funds achieved a 25% IRR, while later funds only exceeded that number 12% of the time.
The trend is clear: smaller is often better in private market investing, but that’s not the only reason to consider smaller funds. They also have less competition.
The investment industry is notoriously competitive. The vacuum of capital allocated to smaller funds relative to their larger counterparts means less competition for the best deals. This allows managers of small funds to cherry-pick the most attractive investments and achieve market-beating returns.
Larger fund managers have the advantage of establishing relationships with LPs, but these relationships often lead to herding behavior and groupthink. This can result in bad decision-making, as managers feel pressure to make investments that will please LPs rather than generate the best returns.
The rise of small funds is a relatively new phenomenon, and it’s being driven by the same market forces benefiting private markets as a whole: the need for higher returns, less volatility, and diversification. But small funds have an extra edge that makes them even more attractive: less competition. Smaller funds are a clear choice if looking for the best returns in private markets.
Diversifying across geographies is another critical consideration for private market investors. While emerging markets are often seen as less performant and riskier, the data tells a different story.
According to an analysis by the World Bank, long-term emerging market returns comparable to those in developed markets can be achieved through a global, diversified strategy. Further studies show that funds focused on emerging markets have demonstrated attractive returns. According to Preqin data, top-quartile net IRRs at emerging funds were mainly above 20% for 2011-2015 vintages.
The outperformance of smaller funds holds up even when you consider these different geographies. A LiveMint analysis shows that small-cap funds in India consistently outperformed in the last year, and a MorningStar India analysis of funds over the last ten years shows that small- and mid-cap funds outperformed large-cap funds by a wide margin.
This year, as venture capital has followed the downturn of public markets, Africa’s venture ecosystem has been one of the few bright spots. Africa set deal count and volume records in 2021, and 2022 is set to exceed those figures. The region has recorded three-digit growth in the first quarter of this year, with venture funding up 150%, hitting a record $1.8 billion, compared to $730 million in the same period in 2021.
This growth is essentially thanks to early-stage deals, including in crypto. The African Blockchain Report reveals that crypto startups in Africa saw more venture funding in the first quarter of 2022 than in all of 2021.
The outperformance of smaller funds is a global phenomenon. No matter where you look, you’ll find that small funds are posting superior returns.
There’s no doubt that smaller funds are getting a tiny slice of the pie when it comes to private market investing. But one segment of the market is bucking this trend: micro-funds.
Micro-funds are private equity or venture capital funds with less than $50 million in committed capital. According to PitchBook data, “the number of micro-funds closed annually has grown from an average of 75 each year between 2006 and 2011, to an average of 320 each year between 2018 and 2021.”
This growth is closely correlated with the rise of seed investing. In the past, it was more difficult for early-stage startups to raise capital, as investors were focused on later-stage companies with more established track records. Smaller funds are the perfect solution for these companies, as they can take on more risk and invest smaller sums of money.
The result is that micro-funds provide an essential source of capital for the most innovative and disruptive companies, which also helps explain their outperformance: A smaller check makes it easier to generate higher returns.
The rise of small funds is good news for the economy, as it democratizes access to capital and allows more companies to start. But it’s also good news for investors. Consider smaller funds if you’re looking to take advantage of the many benefits of private market investing. They’re outperforming their larger counterparts and offer a unique opportunity to get in on the ground floor of the next big thing.
With Gridline, you can access these small, high-performing private market funds with low capital minimums and fees. Gridline is the most efficient way to gain diversified exposure to non-public assets, and our mission is to open up access to top-quartile private market alternative investments. Sign up today to learn more about how we can help you achieve your investment goals.
Section 1202 of the Internal Revenue Code (IRC) provides tax benefits for qualified small business stock (QSBS). This tax break was designed to encourage investment in small businesses by reducing capital gains taxes.
QSBS can be eligible for a capital gains exclusion of up to 100%. However, specific requirements must be met to qualify for this exclusion.
First, a Qualified Small Business must be an active C Corp (not an S Corp) incorporated in the United States, with less than $50 million in gross assets before and after the stock is issued. A QSBS is any stock acquired from a QSB after August 10, 1993, when Section 1202 was originally enacted.
There are also a few industries that are not eligible for QSBS status. These include the broad group of “services” or any business where the principal asset is the reputation or skill of its employees. QSBS does, however, include investments in technology, research and development, and manufacturing. Some states don’t offer QSBS exclusion at the state level, including California, Mississippi, Alabama, Pennsylvania, New Jersey, and Puerto Rico.
To qualify for the QSBS tax benefit, shares must be purchased at the original issue (not on the secondary market) and held for at least five years. Additionally, the investor cannot be a corporation, and the stock must be acquired with cash or property or as compensation for services.
Finally, at least 80% of the company’s assets must be used in the active conduct of one or more qualified trades or businesses.
Section 1202’s Small Business Stock Capital Gains Exclusion describes the tax benefit in detail. In general, the benefit allows non-corporate investors to exclude a portion of the gain from selling QSBS as long as specific requirements are met.
The amount of gain that can be excluded depends on when the QSBS was acquired. For QSBS acquired between August 11, 1993, and February 17, 2009, the exclusion is 50%, and 7% of the excluded gain is subject to alternative minimum tax (AMT).
For QSBS acquired between February 18, 2009, and September 27, 2010, the exclusion is increased to 75%, but 7% of the excluded gain is still subject to AMT.
Finally, for QSBS acquired after September 27, 2010, the exclusion is 100%, including gain excluded from AMT and net investment income tax (NII).
Meanwhile, there are limits on the total amount of gain that can be excluded. The federal government currently allows for a $10 million cumulative limit and an annual limit of 10 times the basis of QSBS sold during the year.
Importantly, taxpayers can claim the entire excluded amount in one year or spread it out over multiple years.
For example, consider a single investor with an ordinary taxable income of $500,000. This puts them in the highest tax bracket for capital gains, which is currently 20%. Assume they sell qualified small business stock, purchased in 2011, five years later, with a realized profit of $100,000.
Typically, this gain would be subject to a capital gains tax of $20,000. However, because the stock qualifies for the best QSBS treatment, the investor can exclude 100% of their capital gain.
This only applies if all the guidelines mentioned above are met. For instance, if that investor was in California, they would not qualify for QSBS status and would instead be subject to state capital gains taxes.
The bottom line is that QSBS can offer tax benefits for investors, but it’s essential to be aware of the requirements and consult with a tax advisor to be sure your situation qualifies.