Getting a Bigger Bagger

January 9, 2017

We had a meeting this past week with a well known, long-term investor in private equity. As you know, we have a keen interest in private investing so we were excited to hear this investor’s thoughts as we started the year.

This private equity investor typically invests capital in smaller, growth related companies. In some instances, these companies are just getting started, and have little in the way of net income, but entrepreneurial, risk tolerant investors are willing to bet on the potentially significant upside.

A key difference between the private and public equity markets is that the private equity market has no liquidity.  In other words, investors cannot get their capital out until a “liquidity event” occurs. These events are typically when another group wants to buy the company. Private equity players refer to the multiples they make on their successful investments in terms of “baggers.” For example, if they are lucky enough to have a $100,000 investment that pays off at $500,000, they will refer to this as a “five bagger.”  I guess an investment that was completely lost would be a zero bagger.

In the course of our discussion with the private equity investor, I asked how he split his personal investments between the public and the private sector. He stated that he usually kept most of his capital in the private sector, and the rest in cash. He explained that his goal was to try and get “ten baggers” on his money, and went on to say “every time I put money into the public market and a stock goes up, I sell it when it’s around a two bagger.” I asked him why he sold so early, to which he answered: “because it’s easy to sell.  I can’t sell my private investments, so it forces me to hold them a long time.” As you know, the typical investment hold for private equity is 10-15 years.

This conversation made me wonder whether investors in public markets would be more successful if they began to think about their investments like our private equity investor does with his illiquid, private portfolio. There is plenty of evidence to show the benefits of long-term investments in the public markets. While not necessarily representative, the thirty-one year period from 1986 to 2016, which includes the three largest down turns since the Great Crash, saw an investment of $100,000 in the S&P 500 grow to a gross $2,162,806 * – nearly a 22 bagger!

Private equity investors will boast that their investments over time produce higher rates of returns than the public markets, but how much of that is due to their inability to sell their illiquid investments. It seems to be a form of forced patience. Yes, the public markets provide the ability to get out when you want, but perhaps a public market investor should think more like a private equity investor when it comes to having the patience to let their money work longer for “bigger bagger” potential.

Carl Gambrell

*Source: Morningstar Direct