What’s going on in private markets and why it matters

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The SpaceX IPO has highlighted how much potential there is in private companies but how do investors get exposure ahead of the game? This week’s guest, Mat Masters, talks about the options available to investors, what they need to understand, and the risks and opportunities of investing here. Mat is chief executive of Caledonia Investments Investment Trust.

0:00 - 0:54 - Intro 
0:54 – 2:43 - Why invest in private assets? 
2:44 – 06:57 - How do they actually fit into a portfolio? 
06:57 – 9:51- What do DIY investors look for? 
9:52 – 10:47 - Sector considerations 
10:48 – 12:34 - Key risks for private assets right now 
12:35 – 16:38 - How closely linked are public and private markets? 
16:39 – 19:44 - The different types of private equity vehicle 
19:45 – 21:35 - What’s best for you 
21:35 - 22:57 - Other things to be aware of 
22:57 - 23:29 - Outro

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Dave Baxter, senior fund content specialist at interactive investor: Private companies are all the rage right now. We’ve seen plenty of excitement drummed up around the flotation of Space Exploration Technologies Corp Class A (NASDAQ:SPCX), and we have some other exciting companies on the same path from Anthropic to OpenAI and some lesser-known names like Bending Spoons SpA (NASDAQ:BSP).

There’s always been this argument that you can tap into greater growth by investing in such companies before they list on the public stock market. However, that entails risks, it entails some complications, and there have been some controversies in the space as well. So, that’s what we’re going to discuss today.

Welcome back to On The Money, the show discussing the issues affecting your savings and investments. I’m Dave Baxter here at ii and today I’m joined by Mat Masters, the chief executive at the Caledonia Investments Investment Trust. Mat, thank you for joining today.

Mat Masters: Great to be here, Dave. Nice to be with you.

Dave Baxter: So, Mat, for context, Caledonia Investments Ord (LSE:CLDN) invests in all sorts of different things, but you do have a decent focus on private assets, whether it’s more direct investments or using funds. 

So, if I want to invest and make money, I’ve been pretty easily able to do that in recent years simply by investing in public assets and listed shares and so on. What is the case for private investments either instead of or alongside shares?

Mat Masters: At Caledonia, we invest across both, so we have that same question the whole time because we have direct private investing where we own six or seven companies at any given time, and then we also invest in private equity (PE) funds, so we have exposure to private assets that way.

We’re always asking that exam question, answering that exam question. For us, we’ve got the ability to do this with the team and everything, and we’re looking at the quality of the business that we’re buying into, the underlying companies, what the qualities are of those, and how much risk am I taking in investing in them? I mean, those are the two questions investors have to visit, isn’t it? How good is this thing? What do I think it’s worth, and what are the risks?

We will pick and choose depending on what the opportunity set is. With private investing as an individual, you’re probably doing it via a fund, an investment trust most likely, and so you need to think about the manager as well. 

So, you need to think about those underlying companies, the risk associated with them, and then also the management of those assets and get to know all that.

Dave Baxter: And if someone were trying to understand how private assets fit into their portfolio, how would you say it differs from going listed? I mean, is it higher risk, higher rewards? Probably a bit more nuance than that.

Mat Masters: So, it can appear lower risk because for private assets, the valuations don’t change that often. So, the wiggly line, as I call it, of progress doesn’t wiggle quite so much with private assets. With listed assets, even listed funds, you’ve got a lot more volatility, so they appear to have different risks. Of course, they’re investing in companies, and they’re taking precisely the same equity risk.

So, don’t be misled by that sort of stability. You need to weigh up the types of assets the manager’s investing in, are they paying high multiples, are they putting lots of leverage against it, how have they been generating their returns over time? Post the great financial crisis, the GFC - just to remind people what it stands for these days, as it was a while ago - interest rates went very low, and private equity had what probably turned out to be a golden decade of very low interest rates.

You could really improve your equity returns by taking out quite a lot of debt, and then that magnified any improvement of value that you enjoyed over that time. So, you have to be careful about looking at that period and expecting that to repeat going forward. It’s quite a bit of homework to do as you’re going into private assets.

I think it is a good area to invest in though. I mean, you can invest behind good-quality managers who perhaps aren’t using lots of leverage, aren’t paying high multiples, and they’ve got high-quality portfolios. It’s a good way of getting behind companies and perhaps we can talk about the way these companies are managed and the alignment that they enjoy, which I think counts towards why they perform well over time.

Dave Baxter: So, what is that alignment? What do you mean by that?

Mat Masters: So, the difference between private assets and public assets, if you boil it all down, is the shareholder, obviously.

In public markets, you’ve got lots of different shareholders. You’ve got a share price every day. There’s a lot of day-to-day investor relations to worry about and be concerned with. When you’re in a private asset, if, say, for example, in our portfolio, we sit on the board.

First of all, we’re very selective about the assets we invest in. All private equity investors do a lot of homework before they invest. The shareholders are really well informed about the asset, the management team, the market when they go on the board. So, you’ve got brilliant understanding of relationship between your shareholder and your management team, and they tend to be long-term holders of these assets. It’s great for management teams being able to invest in their company.

At Caledonia, we’re investing from the balance sheet, so we’re not investing from a fund, so we don’t have to think about recycling the money. And we have a family shareholder in Caledonia that provides Caledonia with additional stability. So, that means that the management team can really have that stable platform and really develop and improve the quality of the business over time.

In terms of return on investment, generally the highest return on investment we’ll get in companies is when they’re able to invest in their overheads, in their P&L (profit and loss), in their sales teams, because the people generally know what they’re doing and they can generate additional revenue or whatever it is and make good progress.

But in the short term, that might bring profit down. That sounds simple, but that’s a complicated story to tell the public markets. But when you’re a private asset, you just talk to your shareholder who’s on your board, and everyone understands what’s going on. So, the investment decisions are a lot easier to do, a lot clearer to do. So, they just have a bit of an advantage in terms of how they’re set up to do well.

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Dave Baxter: I want to return to the point about the DIY investor. As you mentioned, they all tend to be accessing this area through funds, whether it’s dedicated private equity funds, or whether it’s some of the more mixed investment trusts. 

I alluded to earlier things like SpaceX, and Baillie Gifford had a lot of exposure there. But what are the key things a DIY investor should perhaps be looking at if they’re trying to, say, look into one of these funds, understand the process, understand the companies. What metrics and general traits should they be looking out for?

Mat Masters: Well, they should have a look at the portfolio and the companies in that and try and understand if they’re good-quality companies or not. 

Then, in terms of metrics, the things I’d be looking for is how much debt is being used to drive returns. The more debt, the more volatile because, as you know with our mortgages, house prices might change but the bank doesn’t change the mortgage, so it’s the equity bit that feels the pain, and some people can use quite a lot of debt, so you need to watch out for that. It’s great when it works well, but when things come off the boil, it can be painful.

And then also the valuations. Managers generally tell you what the portfolio or the underlying valuations are, and the higher the valuation, the more right about the future you’ve got to be. And we’ve seen it. All those three things lining up when times are good, and it can cause problems when things change.

For example, software as a service is still a good-quality business to be in. The marginal cost of selling a new licence is almost zero, maybe a bit of sales commission and very sticky revenue. So, they’re good businesses and consequently, they are valued quite highly. They’re predictable, so there’s quite a lot of debt in there, and so they are popular assets to own.

But when AI comes along - and we’re yet to see whether the risk materialises, but certainly the perception is that there’s risk around them - the valuations reduce. You’ve got a lot of debt in there, back to that mortgage analogy, and the valuations come under pressure.

So, you need to think through what risk you’re willing to take when you invest in these funds, and when you are after that thing, the SpaceXs of this world, if you like, or whether you want something a bit more stable, so you’re looking for things with less leverage, and perhaps a bit more of a broader portfolio and maybe lower valuation risk in there.

So, those would be the things I’d be looking at.

Dave Baxter: Even with listed equity funds, maybe that sector consideration is quite important. As you alluded to, software can be quite present in some of those private portfolios. And you can also look at maybe how potentially more cyclical a portfolio is and if you look at what sectors are dominant there.

Mat Masters: Yeah, absolutely. If it’s cyclical, if it’s in one sector, you’re just taking on more risk. At any point in time, you might be wondering what the thing is worth. I suppose you trade that with having clarity about the story around the portfolio, a nice clean message, but then you do run the risk of all the eggs being in one proverbial basket when things change, and it’s very hard to predict the future.

Dave Baxter: Yep. And what are the key risks that you see for the sector at the minute that investors might need to be aware of? I mean, we’ve discussed the software issue. You did also earlier mention rates, and rates might potentially stay a bit higher for longer in the wake of the Middle East conflicts.

Mat Masters: Well, they could go up. No one knows actually what’s going to happen with interest rates. We read in the Telegraph about which way they’re going to go, but no one actually knows.

So, the risks are definitely that. So, if you’re in equities, the risk-free interest rates are governing your returns somewhat because if interest rates go up, then your equity returns are going to have to go up and so your valuations today are going to come down. That gets exaggerated if you’ve got lots of debt in there. 

So, there’s quite a lot of PE funds, not Caledonia because we don’t use very much debt because we’re aware of all these risks. We use a couple of turns of debt, really. If you’ve got five, six, seven times debt in there in terms of debt to profit ratio, you’ve got much more of that risk to worry about.

Sure, these PE funds will fix the interest rate on the debt that they have, but at some point, those debt instruments will be required to be refinanced and those fixes will come off, and you’ll have to go to the new rate environment.

So, you do need to be mindful about interest rates. You need to be mindful about markets. If the stock market sells off in a big way, that’s going to make its way into the value of the portfolio, and you need to think about a whole host of other issues in terms of the quality of the assets as well.

Dave Baxter: How great is that correlation with public markets? Because occasionally in the past, I almost hear people trying to describe private assets as a diversifier against public, and I’m never sure quite how well that stacks up.

Mat Masters: Ultimately, they’re both underlying companies that at some point, someone’s got to really work out what they’re valued at and pay some money to buy them. That’s the ultimate test of valuation. 

There’s a phrase though, ‘what happens overnight in the equity markets can take a while to work its way through to the private markets’, and that’s sort of referencing the fact that you might have an equity market sell-off, but the private market valuations don’t change very much.

Now there is a sound reason behind that, and that is when these private assets are valued and everyone follows the guidelines and they’re all audited, so no one’s doing anything wrong, they are considering what a willing buyer and a willing seller would trade at. So, if the stock market has just sold off last week, that’ll somewhat be brought into the thinking, but not completely. There needs to be a persistent change in the market for those assets to work its way into the valuations. So, you do have that difference occurring.

The proof of the pudding is in the eating, and so you can quite often see what value assets are being sold at. That’s quite an interesting reference point. There’s this term ‘pop on exit’ you might have come across?

Dave Baxter: Is that the uplift? 

Mat Masters: That’s the uplift. So we’ve just sold Stonehage Fleming. It’s literally sold, and we got the money in a few weeks ago. We’ve sold it for nearly £300 million, our share of it, having paid £90 million for it in 2019. We’ve told people that versus the March 2025 valuation, so the undisturbed value before the buyer came along a year ago, that’s a 30% uplift that it went at. That’s the pop on exit, that 30% uplift.

That’s been a common pop on exit across our private portfolio for us, and that’s somewhat helpful in letting people see whether we’re overvaluing or undervaluing our assets. Other managers will also provide similar data.

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Dave Baxter: There’s also the volume of so-called realisations and sales of assets, when problems hove into view, you sometimes get a bit of a slowdown with sales. Perhaps that’s also another metric.

Mat Masters: Yeah, that’s a good point, Dave. You’ve certainly got that going on at the moment. People look at realisations and when you’re in boom times, you may see up to 20% of the opening net asset value (NAV) being sold in a year, like high turnover, because it’s a seller’s market and the assets are being sold because the market’s receptive to it. That’s much lower at the moment because of the war and higher interest rates.

So, that’s holding up within funds. I’m going to point out again that Caledonia is a lot of funds, so we don’t have this issue. But within conventional funds with a limited lifetime, not selling assets becomes a problem because you’ve got to return the money, and so you’re seeing continuation vehicles, lots more secondary transactions.

The financial services market is nothing if not entrepreneurial, and so we’ve got lots of wizzy ways of creating apparent liquidity, and the more you see of that, the more you need to question why that is occurring. 

For the occasional brilliant asset, we want to give it a lot more time to run, and you can understand why you do a continuation vehicle, but if it’s becoming a systematic feature of a fund, it’s probably because they’re in trouble selling stuff.

Dave Baxter: Yeah, those continuation vehicles have become much more prominent, haven’t they, in recent years. It might be worth touching on because it’s not something that people automatically know, the differences between things like primary funds, secondary funds, and then direct investments, because often funds will blend these approaches when getting private assets, but they have different characteristics.

Mat Masters: Yeah, sure. So back in the old days, individuals invested into private equity via primary funds. These are 10-year episodic funds, the money’s raised, deployed over the first three or four years, and then they work, manage and sell them, and then money’s gradually returned over the years six to 10 or something like that, and they’re aiming to sort of double your money over that period. 

Over time, the market has evolved. One of the issues with primary funds is it takes a while to get the money in. There’s a feature called the J-Curve, so the valuation goes down because of fees and what have you before it goes up.

As I say, financial services is very entrepreneurial, and so you have secondaries and funder funds and direct investing available, which are various different ways to address those issues, the J-Curve and the speed at which money gets put to work.

So, secondaries are increasingly common. It’s quite a big market now. And that would be when a primary fund is getting towards the end of its life, they might choose to sell the last three assets, let’s say, to a secondary fund. And so that secondary fund is a different investment proposition.

They tend to be concerned about the speed at which they can then sell those assets on. Because the assets have been owned by private equity, there’s a lot more clarity about how things are going, and it’s a sort of time value of money game, and it works pretty well, but it’s a different way of doing private equity, that’s secondary market. It also helps with the liquidity issue that we’ve been talking about. 

You then have directs, which are sort of co-investments generally, and you’re seeing investment trusts - we don’t do this because we do our own directs - but where they might have a primary fund that they are invested in, from time to time, the primary fund will say, do you want to put some money directly into one of the portfolio’s companies we’re about to buy?

So, if we’re paying a £100 million for it, we’ll put £50 million in from the fund, and the other £50 million will come from the parts of that fund directly. The benefit of doing that is that you generally pay less fees on that, so that saves you a bit of fee money. 

So, you’ve got different ways of essentially playing the same game and it’s addressing the fee drag and the time and the speed at which your money goes to work. 

Dave Baxter: For DIY investors, maybe they just need to consider the funds available to them. Some are much more concentrated and you can look at the companies, and you get some funds that may actually just have, say, 20 investments or so. And then the funder fund model where you could have thousands of underlying companies, so it’s harder to analyse but it’s more diversified.

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Mat Masters: In investing, you’ve got to understand yourself first. I also think when you invest, it’s all very nice to think about how things will be when they go well. You really have to think about how you’re going to react when things don’t go well.

If you’re a long-term equity investor, there’ll be periods when things don’t go well, and you’ve got to figure out what are the things I’m going to need to understand without having to Google every other word, so that I can understand what’s going on when things are going badly. Because I might have to sell, that might be the right decision or the right decision might be to hang on and hold. 

You’ve just got to work out, what are the sort of things that you’re going to need to hang on to when things go bad. I’ve been at Caledonia for 20 years through thick and thin, and one thing I’ve learned is having good-quality companies, and almost no debt means that when things go bad, you can go home and sleep at night.

For me, that’s important. When things go well, upside almost takes care of itself. You don’t have to worry quite so much about that. But other people might have different risk/reward views. People investing in SpaceX will have quite a different risk/reward view than I would, for example. 

Dave Baxter: Very different ways to do it. And, finally, we’ve covered a lot of ground, but were there any other key trends in the space that you would highlight or anything that investors need to be aware of if they’re thinking of getting into it for the first time?

Mat Masters: Well, when you’re doing anything for the first time, do it gradually. Have a number in mind that you’re wanting to put to work and just do it in stages over time. The last thing you want to do is pick a day to create your new exposure to whatever it is, because you [might] get a bit like Gordon Brown selling the gold. You might pick the absolute worst point in the market.

So, I would say do as much homework as you can do. Make sure you’re comfortable with what it looks like and how it smells and everything, that you’ve got the things there that you need, and then just do it gradually.

It’s a long-term game, investing, especially private market investing. It takes a long time for the companies to do their work and improve, and for the value creation exercise to occur, so you’re unlikely to miss anything. Just take your time over it. Don’t pick like a Tuesday afternoon or whatever it is to do it, please. Slow and steady.

Dave Baxter: Well, thank you for your time.

Mat Masters: Thank you, Dave.

Dave Baxter: And thank you for watching and for listening. As always, do let us know what you think either via the comments or by emailing us directly at: otm@ii.co.uk. Thanks again, and take care.