the investor's paradigm

In part 1 of our survey findings, we presented three distinct groups of ordinary investors. In part 2, we discussed common concerns among likely and less likely SME investors. But what are the main reasons for small investors that would justify investing hard-earned money in alleged risky startups and SMEs?

Not surprisingly, for all survey participants, risk/return as well as diversification considerations are the main drivers for such an investment.

For those individuals who are likely to invest, based on interest, risk profile and willingness to invest time (group 3 = 8.5% of investors), the joy of contributing own skills and expertise to the venture is seen to be another important factor. This non-economic factor, however, is closely related to economic considerations as the majority of this group is confident of being capable of adding value through their personal involvement in business matters (often referred to as “smart money”).

In addition, individuals from this group (as opposed to groups 1 and 2) underline the importance of diversification, indicating that having an investment outside the established financial markets would be an important factor.

Being confronted with other potential non-economic or altruistic motivations, group 3 reacts at best neutral. As if to underline the paramount importance of economic considerations, the average group 3 investor even disputes that the promotion of the local economic development through support of SMEs and young entrepreneurs would be an important reason to get involved.

In short: the majority of group 3 couldn’t care less about non-economic factors. Being clear-cut homines oeconomici, they consider SME investments to be yet another investment opportunity economically competing against other offerings. No time for romance.

Group 2, all individuals with an interest to invest but not belonging to group 3 (35%), also attributes paramount importance to risk/return considerations but their motivational profile is much more complex. So far, all participants within that group indicated at least some degree of agreement with respect to all altruistic and most non-economic factors. In particular, they are more likely to become involved if two non-economic factors are taken into the equation: The average group 2 investor aims to support innovative ideas and young entrepreneurs.

In consequence, there is a huge potential for raising risk capital from an even broader public and beyond the homines oeconomici, if capital seekers succeeded to address two issues. Firstly (and as discussed in our previous post), the most common concerns of group 2 have to be dispelled. And secondly, the innovativeness and social relevance of a business opportunity needs to be communicated.

Participants were asked to give answers even if they did not indicate an interest in SME investments. And given the hypothetical nature of this scenario to group 1, results need to be interpreted very carefully. One finding however is noteworthy: altruistic and non-economic factors play an even more important role than for group 2 and 3 participants.

If we take into consideration some of our previously published findings, we can draw some first conclusions on how motivations of small investors differ from those of formal VCs and other informal investors.

1. Small investors are equally focused on the economics of an investment but have more patience/long-term orientation than formal VCs
2. As opposed to formal players, the majority of potential small investors take additional non-economic factors into the equation
3. However, in comparison with other informal investors in the friends and family space (often driven by friendship and favors), small investors are clearly more economically minded

Quite clearly, if we want to pinpoint typical behavioral profiles of likely investors, it will be necessary to do a more detailed segmentation based on our data. Come back, we will do that soon – and in the meantime, let us know your thoughts on what could be feasible dimensions to slice and dice groups 2 and 3!

Survey: N=176, including only participants from Germany, Switzerland and Austria in evaluations

As a result of our survey on investor behaviour, three distinct groups of ordinary investors emerged (see post Survey findings, part 1: A different take on small investor interests). Group 1- individuals who would not invest in SMEs or startups (56.5%), group 2 - individuals with an interest to invest (35%), and group 3 - individuals who are ready to invest, based on interest, risk profile and willingness to invest time (8.5%).

We will be analyzing investors’ concerns along these groups. With respect to group 1, we will try and establish key reasons that are keeping people from considering this type of investment (besides other aspects like for instance lack of interest). Regarding group 3 (people who are likely to invest), we will try to find out where they would lay emphasis on in the due diligence phase - given an appropriate SME or startup could be identified. And as for group 2, we will try to assess to what degree and under which circumstances these people would become likely investors in the future.

The chart below gives an overview of concerns along with a rating (strongly disagree to fully agree) for each group. The three groups consistently express different levels of concern throughout all questions. Each group corresponds to a distinct concern profile which we will enlarge upon.

People not considering an SME or startup investment (group 1) share all concerns listed, the top three being:

1. “Due to a lack of own experience, I do not feel comfortable with such an investment”
2. “I would be concerned that the information I have available when deciding on the investment are not comprehensive or not entirely correct”
3. “I would generally be afraid to loose money with such an investment and stick to traditional investments”

This expresses a general fear or hesitation, relating to a lack of experience or a fundamental mistrust in such kind of investment. Based on these fundamental barriers, a more in-depth discussion of more specific concerns would bear no additional insights.

For those ready to invest (group 3), only two concerns are seen to be of some importance:

1. “As I do not know the owners or the management of the company, I am afraid that they may not be up to their management task”
2. “I would be concerned that I would not be kept informed regularly”

Individuals from this group do not share any of the other potential concerns (a value of zero indicating a neutral attitude, this group rates concerns not mentioned above below zero). This of course does not imply that these people deem the majority of concerns as illegitimate, but rather as resolvable. Clear disagreement is expressed, if we are insinuating a lack of experience or fear with respect to such kind of investments. Their concerns are specific to a given opportunity, circling around trust in the management team and post-deal reporting.

Let’s take a closer look at group 3. Strikingly enough, the so-called exit option, the way in which a private equity investment can be liquidated, is not overly high on the agenda of small investors. This finding is particularly interesting, as it is well known to be an important factor for business angels and institutional players, when placing their investments. Typically, the latter are seeking an exit in 3-8 years in order to free up resources – in the case of institutionals also pressed by their own investors, and generally are mostly motivated by purely economic factors. It appears that in this regard, the small investor distinguishes itself through increased patience and potentially different/additional investment motivations – an assumption we will be validating in a subsequent post on the survey results. It is important to note, however, that many small investors are simply not familiar with various aspects of such an investment; this most certainly includes the divestment mechanics.

Also noteworthy is the fact that likely SME and startup investors state, they would not be frustrated if an investment turned out to be unsuccessful. Taking into account the potential high risk associated with an SME or startup investment this is another confirmation of their entrepreneurial mindset.  

To complete the picture, let’s cast some more light on group 2 and assess how high a barrier their concerns pose and under what circumstances they would still adopt this type of investment. The group indicates that they would feel quite comfortable with this type of investment and that they would not be afraid of loosing money. Nevertheless, as opposed (and in addition) to group 3 (people likely to invest), there are a number of concerns shared with group 1 that would have to be addressed: comprehensiveness and correctness of information, potential liquidation difficulties, coordination with other small investors and fraud risks.

In summing up, we are seeing quite fundamental concerns for group 1, making it quite clear that they would only take the plunge in exceptional cases. Group 2 feels generally comfortable with such an investment. Before they would invest in an SME or startup, however, probably most of them would want to get more clarity around what such an investment entails. Group 3 clearly has the mindset of the entrepreneur and SME / startup investor.

Survey: N=176, including only participants from Germany, Switzerland and Austria in evaluations

Private equity is for affluent individuals with an attitude, as many people see it. And this notion clearly reflects in the portfolios of small investors. Further is it fortified by some recommendations of business journalists and bankers to their readers or clients respectively, to stay away from this kind of investments. Last but not least: under the banner of investor protection, regulators do their best to maintain the status quo.

An ongoing market study we are conducting sheds a new light on small investors' interests in this regard. Our preliminary findings show that over 40% of investors (defined as someone of minimal wealth) have indicated that they would consider a direct private equity investment in an SME or startup and that they would value improved access to such investment opportunities. This is roughly eight times of what reality is showing today.

Even under more restrictive criteria, requiring not only a clear interest but also preparedness to invest time and accept associated risks, 8.4% of investors or roughly 3.64 million people in Germany, Switzerland and Austria would invest part of their money in new ventures or SMEs. This portion includes individuals already invested in private equity today (currently roughly 3%, read here) and, to a large extent, individuals with an entrepreneurial background or advanced investment track record, in the sense that they have invested in more than one asset class.

Note: 56% stated that they would not invest in this type of investment (including a few participants that gave ambiguous answers).

Interested SME investors are almost exclusively in jobs entailing “independent and qualified” or “highly demanding” tasks (job level categories 1 and 2 out of 4 of the Swiss Federal Statistical Office), with a focus – but not predominantly – on economic, finance and law backgrounds. Men are more likely to invest than women whereas the marital status and family situation do not play a significant role.

While it is not surprising that wealth and income play a role in people’s interest to invest, the study shows that there are many people below the threshold of the so-called accredited investor (according to the SEC, a net worth in excess of $1 million or income of >$200k) that are likely to invest. Figure 2 shows the percentage of investors likely to invest by wealth group, increasing sharply and peaking at 16.5% for individuals with of wealth between $100k and $200k. Declining interest with higher net worth could potentially relate to further alternative investment offerings accessible to these individuals.

The apparent demand clearly raises the question of why no corresponding offering for small investors can be found in today’s markets. We will approach this question from a number of perspectives in subsequent posts, including investor concerns (see Survey findings, part2) as well as regulatory and non-regulatory aspects of the market. (See blog the paradigm, part 3: Legitimate concerns or inefficient markets?). Should a corresponding offering emerge, it will be even more interesting to see how many of the 34.9% already considering SME or startup investments today, will take a more active interest.

At this point however, we simply note that the percentage of investors who are likely to invest in private equity is significantly higher than the percentage invested today. It will be an interesting discussion to lead, how and to what extent this additional source of private funds can contribute to funding a larger portion of startups and SMEs in need for financing - today, more needed than ever. Governments are currently evaluating a myriad of options to support this. However, it will be challenging for them to strike the right balance between their mandates to protect small investors and letting small investors take an active and responsible role.

Along those lines: the financial crisis has taught us that too much trust of investors in the “system” or external advice is not only dangerous for the individual investor, but also eliminating some of the checks and balances for the entire economy - controls that, amongst others, regulations were meant to provide. Maybe some of these checks and balances can be put back in place by letting society vote – by means of investing – not only on large corporates but on smaller and/or upcoming enterprises, as well. This voting mechanism works well if voters are experience and well informed. The study shows that people who are likely to invest bring this to the table.

>> Survey findings, part 2: Investor concerns

Check back soon to read additional findings from the market study such as small investors’ motivations with regard to private equity investments as well as how much they are prepared to invest.

Survey: N=176, including only participants from Germany, Switzerland and Austria in evaluations; in these preliminary findings, no corrective factors have been applied to eliminate potential bias in the sample population