Reflecting on a decade of private company investing

Scottish Mortgage has now been investing in private companies for over a decade. We began this journey in 2012 when Yahoo! was looking to off-load its stake in the Chinese ecommerce behemoth Alibaba. It was a fortuitous start to private company investing.

The Company’s £30m holding became worth more than £150m just two years later when Alibaba launched what at the time was the world’s largest-ever stock market flotation. The Company’s private company exposure has expanded over the decade since, giving our shareholders access to a range of differentiated businesses, many of which have no public market equivalent.

From SpaceX radically lowering the cost to access space; to Northvolt providing crucial homegrown battery production for the European market; to Tempus Labs developing personalised cancer diagnoses powered by artificial intelligence. Our private company exposure is concentrated in a small number of these very large private businesses.

The companies that make up the bulk of our private company exposure are consequently neither small nor early-stage. We have several private holdings that already have many thousands of employees and billions in annual revenue. The majority of our assets invested in private companies are in businesses which would be large enough in scale to join the FTSE 100 Index, if they were based in the UK and listed. 

Access is an advantage

The second reason we invest in private companies is that we believe we should have an edge in doing so. Public companies can choose whom they speak to and we are privileged in terms of the access we get. However, private companies do not just choose who they talk to but also take great care in picking who is allowed to own their shares.

For the most exceptional private companies supply of capital often dwarfs the amount they wish to raise. It is usually a good signal when a meeting with a new private company resembles a two-way interview process. Our reputation as long-term owners of businesses and our closed-ended structure make us stable shareowners which is attractive to private companies.

The good access we consequently receive is evidenced by over 90 per cent of our investments in private companies coming from proprietary sources in recent years. That means coming from a company approaching us directly or an introduction from another founder or investor as opposed to a bank-sponsored funding round.

Insights without boundaries

Investing in private companies has also provided us with an entirely new world of insights to leverage over the last decade. Understanding how the world is changing solely through public companies now feels akin to trying to construct a puzzle with half the pieces missing.

Ant Group helped us to better understand the potential of MercadoLibre’s payment arm earlier than would otherwise have been the case. While a tour of private AI chip companies in the Bay area back in 2018 helped us to better understand the threat of those trying to disrupt NVIDIA. Meituan helped us understand the potential of food delivery across the globe.

Private company investing has continually provided us with a lens into the future. Today it is allowing us to better understand emerging areas such as synthetic biology, artificial intelligence and climate solutions. It has also allowed us to get to know companies well before they go public. We have now had 35 of our private holdings transition to listed companies.

Getting to know Spotify, Meituan, HelloFresh and many more before they went public gave us a far more informed perspective than meeting them for the first time on a highly choreographed IPO roadshow with a team of investment bankers in tow. Over 40 per cent of Scottish Mortgage’s assets are invested in companies that were first purchased as private companies. Private company investing has become an important funnel for the public part of our portfolio.

Low-cost access

The ability to invest in world-leading private companies has traditionally been neither accessible nor cheap. Scottish Mortgage is able to offer access to both the world’s leading private and public companies for an annual fee of 0.34 per cent. In doing so we believe Scottish Mortgage plays a role in democratising access to private companies at low cost.

A decade of learning and building

When we began investing a decade ago there was much we did not know. The infrastructure we would need to do this at scale did not exist and took time to build. Nevertheless, we sensed an opportunity and proceeded cautiously but deliberately allowing us to learn and build the internal capabilities required.

Today we work alongside a team of seven dedicated private company investors as well as 30 investors who work on both public and private companies. In addition, we have an in-house Private Companies Legal Team to manage aspects such as non-disclosure agreements, term sheets and legal due diligence.

Private company valuations

We also have a Private Company Valuations Team whose work has attracted far greater attention than ever before over the last year given the volatile conditions. As Scottish Mortgage has a daily reported NAV (net asset value), it requires a robust valuations process to ensure our valuations are kept as up-to-date as possible.

The aim of the valuations process is to hold private companies at ‘fair value’. In other words, the price we believe we would get were we to try to sell our shares. This process is carried out by Baillie Gifford’s Private Company Valuations Team which takes advice from an independent third party, S&P Global.

Valuations are then approved by Baillie Gifford’s Valuations Group which comprises five voting members all independent of those making investment decisions. Scottish Mortgage’s investment managers, Tom Slater and I are informed via email after any valuation changes have been applied.

The fair value assessment itself is carried out on a rolling three-month cycle. This means that a third of the private component of the portfolio is valued each month. However, this frequency is only the bare minimum. In practice, the pricing of private companies is monitored continually with ‘trigger events’ such as a funding round or change in fundamentals prompting revaluations, outside the three-monthly cycle.

The two most common triggers over the last year have been changes in the value of publicly listed comparator companies or comparator indices. A 5 per cent movement in either was sufficient to trigger a re-assessment. In total 532 revaluations were made with 84 per cent of the private instruments held re-valued five times or more:   

Source: Baillie Gifford. Scottish Mortgage private company valuation changes, year to 31 March 2023.
* Source: Morningstar. Total return for NASDAQ composite. 12 months to 31 March 2023 in US dollars.

Finally, the private company valuations also receive external checks in three key ways.

• First, the Audit Committee of Scottish Mortgage meets twice a year specifically to review the valuations. -
• Second, the valuations are subject to the annual scrutiny of our auditors PwC.
• Finally, because Scottish Mortgage’s largest private holdings are also held by other Baillie Gifford funds, this subjects them to checks by different auditors. Moreover, these checks occur at different points throughout the year due to these trusts having different financial year-ends.

Private company allocation

When we started private company investing there was no limit in place. As the proportion invested in this area grew, the Directors felt it appropriate to provide shareholders with more clarity. At the annual general meeting in 2016, shareholders approved an update to the investment policy to include a limit for private companies of 25 per cent of the total assets, measured at the time of purchase.

In 2020, this limit was raised to 30 per cent, where it remains. That limit only applies at the time of purchase. This means that when the level is exceeded no further private company purchases can be made. However, it also protects Scottish Mortgage from being forced sellers of private companies purely due to relative or absolute movements in the value ascribed to either private or public assets.

Over the course of the financial year we were able to deploy £281m into private companies during the financial year. This included follow-on investments as well as two new private investments in UPSIDE Foods and Climeworks. The proportion invested in private companies stood at 28.6 per cent as of 31 March 2023. This figure is primarily influenced by the value of our public market investments and the valuation changes in our private companies.

However, it is also impacted by buybacks and gearing. An important influence over the last year has been the closing of the IPO market. We had fourteen companies go public in 2021 but as the IPO market closed in 2022 companies postponed their plans with no private holdings going public. We will continue to closely monitor the proportion of the Company invested in private companies throughout the year recognising that the proportion can be volatile.

Should the Company experience material, prolonged and disadvantageous impact stemming from this or any other facet of our investment policy we would naturally seek to sound out the views of our shareholders to understand their perspective. 

Looking forward

Tom Slater has helpfully provided examples of private companies that have made encouraging progress over the course of the last year. However, we are also cognisant that there has been a material change in the funding environment. We have transitioned from a period of capital abundance to one of capital scarcity. We have seen several of our companies successfully raise further capital in this environment while a number of our private holdings are already generating positive cashflow.

Moreover, we are seeing companies bring down their cash burn materially. Nevertheless, it is likely that a few of our smaller private company holdings may find themselves casualties of this new environment. Should this happen we expect the impact to represent only a small percentage of the portfolio’s assets. As ever, our performance will be primarily driven by those companies that succeed rather than those that fail.

Over the past decade our private exposure has grown to become an integral part of Scottish Mortgage. It has expanded our opportunity set from which to identify outliers. It has provided insights that would have otherwise been out of reach and we believe it offers our shareholders exposure to exceptional hard to access growth companies at a low fee level.

As we look to the future perhaps it is only right to let one of our private holdings have the final word. The founders of payment processing giant Stripe write in their shareholder letter that the propensity to start new businesses has increased significantly and persistently. The US Census data supports this showing that the rate of business formation has increased by 44 per cent since 2019. As they reflect:

The role of Scottish Mortgage will continue to be to support that growth in entrepreneurship in good times and bad, whether public or private and through doing so generate long-term returns for our shareholders. We are intensely grateful for the continued trust our shareholders place in us and for their patience particularly over the last year.

Past performance is not a guide to future returns.

The trust invests in overseas securities. Changes in the rates of exchange may also cause the value of your investment (and any income it may pay) to go down or up.

The trust invests in emerging markets where difficulties in dealing, settlement and custody could arise, resulting in a negative impact on the value of your investment.

The trust has a significant investment in private companies. The trust’s risk could be increased as these assets may be more difficult to sell, so changes in their prices may be greater.